What Is a Debt Fund and How Does It Work?

You may have several financial goals and all of them may not require the same investment approach. There are different categories of mutual funds that cater to different needs, risk appetites, and investment horizons. Debt funds are one such category. Find out what a debt fund is and how it works, so you can invest in it for your varied goals.

What is a debt fund?

A debt fund is a mutual fund scheme that invests in fixed income securities such as corporate bonds, treasury bills, certificates of deposit, commercial papers, etc. Often, debt funds are called low risk investments. But have you wondered why? Well, it is because the securities they invest in have a fixed maturity period and interest rate. So, naturally debt mutual funds are unaffected by market volatility and hence, they have relatively low risk. That said, they are exposed to certain risks like credit risk, interest rate risk, etc.

Types of debt mutual funds

The Security and Exchange Board of India (SEBI) classifies debt funds into the following 16 types:

1. Overnight fund:These invest in overnight securities with a maturity of up to a day.
2. Liquid fund: Liquid funds invest in debt and money market securities that have a maturity of up to 91 days.
3. Ultra-short duration fund:Ultra-short-term funds invest in debt and money market instruments such that the portfolio’s Macaulay Duration is between three and six months.
4. Low duration fund:These invest in debt and money market instruments such that the portfolio’s Macaulay Duration is between six and 12 months.
5. Money market fund:They invest in money market instruments with a maturity of up to a year.
6. Short duration fund:These short term mutual funds invest in debt and money market instruments such that the portfolio’s Macaulay Duration is between one and three years.
7. Medium duration fund:They invest in debt and money market instruments such that the portfolio’s Macaulay Duration is between three and four years.
8. Medium to long-duration fund: They invest in debt and money market instruments such that the portfolio’s Macaulay Duration is between four and seven years.
9. Long duration fund:They invest in debt and money market instruments such that the portfolio’s Macaulay Duration is more than seven years.
10. Dynamic bond fund:These funds have varying maturity periods depending on the interest rates.
11. Corporate bond fund: These funds have a minimum investment of 80% in corporate bonds rated AA+ and above.
12. Credit risk fund:These funds have a minimum investment of 65% in corporate bonds rated below AA and below.
13. Banking and PSU fund: Banking and PSU fund invest a minimum of 80% in debt instruments of banks, Public Sector Undertakings (PSUs), and public financial institutions.
14. Gilt fund:They invest a minimum of 80% in government securities with varying maturity periods.
15. Gilt fund with a ten-year constant duration:They invest a minimum of 80% in government securities such that the portfolio’s Macaulay Duration is 10 years.
16. Floater fund:They invest 65% of their total assets in floating rate instruments.

You must be wondering what Macaulay Duration is. Well, by definition, it is the time taken for the principal amount of a bond to be repaid from the internal cash flows generated by the bond.

Too complex? Don’t worry, what are examples for?

Suppose the face value of bond X is Rs. 2000 and its coupon rate is 8%, then the annual interest payout will be Rs. 160 (8% of 2000). In this case, the Macaulay Duration of Bond X will be 12.5 years (2000/160).

How do debt funds work?

Debt funds invest in fixed-income securities. These securities have a fixed interest rate and maturity period that is selected by the issuing entity. Fixed-income securities also have a credit rating that helps you understand the issuer’s default risk and choose high quality debt instruments. The higher the rating, the less likely is the issuer to default on returning the principal investment amount and interest earned on your investment. Debt funds are also susceptible to interest rate changes. The bond price is inversely related to the interest rate. So, when the interest rate increases, the bond prices come down and vice versa.

Benefits of debt funds

When you choose debt funds for your mutual fund investment, you can get the following advantages:

• High liquidity:Debt funds have relatively low maturity periods, which make them ideal for short-term goals. You can redeem your money for any immediate needs as there are no lock-in periods.
• Stability:Debt funds are comparatively stable and less volatile as they are not dependent on the stock market. Moreover, debt funds can generate better returns than several other traditional investment options.
• Multiple options:The different types of debt funds can help you meet distinct needs and goals.
• Professional portfolio managers:Since an experienced fund manager manages your debt fund, all decisions are taken after a careful evaluation of credit risk, interest rate risk, etc.

Taxation of debt funds 

Long term capital gains on debt funds are taxed at 20% after indexation on investments held for more than three years. Indexation considers the impact of inflation on your investment and helps you lower your tax amount. On the other hand, your short-term capital gains are added to your income and taxed accordingly if you redeem your investment before three years.

Should you invest in debt funds?

A debt fund can be suitable if you have a low risk appetite as such funds are less volatile than equity funds and can deliver stable returns. They can also be ideal for short-term goals because of the short maturity periods. Moreover, you can invest in debt funds if you wish to diversify your equity-heavy portfolio. Having said that, debt funds are not entirely risk-free. They do carry some risk, as do all mutual funds. But the risk involved is relatively lower.

Conclusion

Now that you know what a debt fund is, you can make better investment decisions and pick suitable mutual funds per your goals. However, remember to always research well before you choose a fund and understand the risks and costs involved. This can offer you more peace of mind and increase the chances of reaching your target as per your expectations.

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