While commuting to work, you catch a glimpse of the same billboard every morning. It says something along the same lines of ‘Get rid of all your financial worries by investing in best debt mutual funds.’ You might find it amusing. If it were that easy, wouldn’t everyone be rich?
But what if we told you, it is not that hard or out of reach either? Because with every little eye roll or shrug at such billboards, people instantly dismiss the thought of wanting to expand their investment options. Sticking to traditional investment schemes provide sustenance but do they hold the power to aid your financial growth? Or do you find yourself compromising your dreams?
We could help you understand what debt mutual funds are, and why people have become so receptive towards them.
What are debt mutual funds?
Debt mutual funds are also called fixed-income funds. This is because the fund manager invests in fixed income instruments like corporate bonds, government securities, money market instruments, treasury bills, etc.
These funds have a predetermined maturity date and are not subject to market fluctuations. At a low risk profile, debt mutual funds provide steady income. However, as they carry a minimum rate of risk, the income that they generate is comparatively lower than that of equity funds.
Who should invest in debt mutual funds?
As debt mutual funds have low volatility, they are ideal for investors who possess a low to medium risk tolerance and are satisfied with low income as long as it is stable.
What is the difference between a debt mutual fund and a fixed deposit?
Even though debt mutual funds and fixed deposits are two separate investing concepts, they may strike as similar. Yet they are not quite the same. So, in what ways do they vary from one another? Or which is the better alternative?
Let us clarify the basic differences between the two investment options.
Debt mutual funds
- Low to moderate risk that includes inflation risk, credit risk, etc.
- High liquidity
- Associated with the market
- Does not guarantee the security of your principal amount
- Can choose between a lump sum or SIP investment
- Higher returns
- Negligible risk
- Low liquidity
- Not associated with the market
- Pays back the principal amount along with interest at maturity
- Pays a fixed rate of compound interest only at the end of the term
- Can only opt for lump sum investment
- Lower returns
The bottom line is, a fixed deposit may be a safer investment channel, but it might not provide overwhelming returns. Whereas a debt mutual fund provides a higher scope of returns but carries more risk compared to the fixed deposits.
Based on these above-stated distinctions, you can determine which option works best according to your requirements, goals, and risk appetite. You could also opt for a combined investment option and invest in both debt funds as well as fixed deposits.
But for now, we shall dive into the ocean of the types of debt mutual funds.
What are the types of debt mutual funds?
SEBI has introduced the following 16 debt mutual fund categories:
1. Overnight fund:
An overnight fund is a great investment option for people seeking short term gains. It is an open-ended mutual fund scheme that will invest in overnight debt securities maturing on the very next day. Due to this, they are not exposed to any uncertainties and have a near-zero credit risk. Out of all the other debt mutual fund schemes, an overnight fund is considered the safest. Consequently, their returns are also the lowest.
2. Liquid fund:
These funds invest in debt securities and money market instruments like commercial papers, treasury bills, etc., having a maturity of up to 91 days. Liquid funds have the potential to offer better returns than a savings bank and pose as a good short term investment alternative. However, they are also sensitive towards credit risks.
3. Ultra-short duration fund:
This scheme invests in debt and money market securities with a Macaulay duration between three to six months.
A Macaulay duration measures the time for which an investor would have to wait to recoup all the money that was invested in the bond via interest or principal redemption. A Macaulay duration is measured in years. It is a weighted average time period over which the cash flow is received. In other words, it is when the bond gets matured.
Ultra-short duration funds carry less risk and usually provide better returns as compared to savings accounts or fixed deposits.
4. Low duration fund:
Low duration funds are open-ended debt schemes that invest in money market instruments with a Macaulay duration between six to twelve months. They provide good short term returns but due to the extended duration, they are riskier than ultra-short duration funds.
5. Money Market fund:
Money market mutual funds only invest in cash and cash equivalents and have a maturity of up to one year. The fund manager invests in liquid instruments like treasury bills, commercial papers, etc.
6. Short duration fund:
These funds invest in money market securities with a Macaulay duration between one to three years. Apart from short term instruments, they can also invest in government bonds, debentures, etc.
7. Medium duration fund:
Medium duration fund schemes invest in debt securities with a Macaulay duration between three to four years. These funds are apt for investors who have an investment horizon of 3 to 4 years to meet a financial goal.
8. Medium to Long duration fund:
These funds invest in debt securities with a Macaulay duration between four to seven years. Medium to long duration funds provide high returns but are subject to interest rate risks. If there is a rise in the economy’s interest rate, the bond prices will decrease and vice versa.
9. Long duration fund:
These are debt schemes that invest with a Macaulay duration of more than seven years. They provide higher returns than the other types of debt mutual fund schemes. Even though long duration funds are riskier, they are still safer than equity funds.
10. Dynamic bond fund:
In Dynamic bond funds, the fund manager invests in debt securities of varying maturities. The investment portfolio will keep changing according to the interest rates. Dynamic bonds invest in both long term and short term instruments.
For example, if the interest rates are expected to fall, the fund manager will invest in a long duration fund. Accordingly, if the interest rates are expected to rise, the fund manager will divert the investment to short duration funds.
11. Corporate bond fund:
Unlike the other types of funds that we went through so far, these bonds do not invest in the duration of the securities. Instead, corporate bond funds base their investments on the credit rating of securities. They invest a minimum of 80% of their total assets in corporate bonds having high ratings. They provide good returns at low risk.
12. Banking and PSU fund:
These funds invest a minimum 80% of their total money in the securities of PSU (Public Sector Undertakings) and public financial institutions.
13. Guilt fund:
Guilt funds invest a minimum 80% of their total assets in government securities. These investments are done across different maturity periods.
14. Guilt fund with 10-year constant duration:
These funds also invest a minimum 80% of their total assets in government securities. But they can only do so for a duration of 10 years.
Both guilt funds carry the lowest risk as they invest in government securities.
15. Floater fund:
These funds invest a minimum 65% of their total fund money in floating rate instruments. Floater funds are an open-ended scheme that provide returns in correspondence to the interest rates.
16. Credit risk fund:
These funds also invest in corporate bonds but are rated below the ones that corporate bond funds invest in. Credit risk funds invest a minimum of 65% of their total assets.
A list of 16 types of funds could feel overwhelming. We get it. But you don’t need to be confused. Let us guide you through these four simple things to keep in mind while selecting the fund that is most suitable to your needs and objectives.
How to select a debt mutual fund?
These four parameters need to be inspected before selecting a mutual fund.
1. Credit rating:
Companies with a high credit rating have lower chances of defaulting whereas companies with lower credit ratings have higher chances of defaulting. Going for mutual funds that invest in companies with a high credit rating is always better.
2. Modified duration:
A modified duration expresses the change in the value of the bond based on the interest rates. In simple words, it measures the sensitivity of a bond price. Debt funds with a longer modified duration face a greater movement in the NAV as opposed to debt funds with a shorter modified duration.
3. Yield to maturity:
It indicates the total rate of return that a fund can potentially generate till its maturity. A higher yield to maturity will mean that along with the returns, the risk will also be high. Longer duration funds tend to provide a higher yield to maturity.
4. Concentration of risk in the portfolio:
It refers to the proportion of investment that the fund invests in a specific bond. The higher the concentration of investment in one particular bond, the higher will be the level of risk due to the lack of diversification.
How is tax calculated on debt mutual funds?
If the debt fund is held for less than 36 months, the profit that you earn will be added to your total income and taxed according to the tax slab rate.
In case of long term capital gains where the debt fund is held for more than 36 months, the total gains will be taxed at 20% with the benefit of indexation.
Investing in a debt mutual fund has its own pros and cons. And each person has a different financial goal that needs to be met with a unique investment plan. It is natural to feel confused in choosing an investment option from all the blogs you read or billboards you see. This is why our top advice has always been in consulting a financial advisor.
Have an expert understand your wealth portfolio and curate a plan that specifically incorporates all your personal elements like risk appetite, objectives, desires, current financial conditions and other relevant factors. This will give you the confidence to embark on your financial journey of growth and maybe increase your investment appetite each time you read about some new investment policy.
Disclaimer: The views expressed in the blog are purely based on our research and personal opinion. Although we do not condone misinformation, we do not intend to be regarded as a source of advice or guarantee. Kindly consult an expert before making any decision based on the insights we have provided.