What is Debt Mutual Fund? It’s working and Types of Debt Funds

by Rishabh Jain
Debt Mutual Fund

What is Debt Mutual Fund?

Debt Mutual Fund invests in debt securities that generate a fixed income, like money-market instruments, government securities, corporate bonds, etc. An investor earns fixed income in the form of interest payments on maturity. These instruments have a pre-decided maturity date and the rate of interest that will be paid to the investor along with the principal amount on maturity.

How do Debt Funds Work?

As we know, that Debt Funds invest in Debt securities. But what exactly debt securities are?

The companies or other entities like Government raise funds by borrowing money from you and they issue the debt instruments. In return, they offer you interest payments along with the amount they borrowed from you, on the maturity date. For example, Companies issue Corporate Bonds in return for the sum they borrowed.

Credit Rating Agencies provide ratings to these debt securities according to the level of risk they have, i.e. Default Risk. The Debt Mutual Fund Manager generally refers to these ratings to select High-Quality securities. The higher the rating, the less are the chances that the issuer will default. A higher credit rating implies that the issuer will pay the interests regularly along with the principal amount on Maturity.

Types of Debt Funds

Debt Funds are classified in the following types:

1. Money Market Fund

Money Market Fund invests in different types of Money market instruments like Promissory Note, Treasury Bills , Commercial Paper, etc. with a maturity period of 1 year.

2. Liquid Fund

The Funds that can be easily converted into cash i.e. within a day or two, are known as Liquid Funds. These funds invest in highly Liquid Money market instruments (Treasury bills, commercial papers, etc.) that have a maturity period of up to 91 days.

3. Dynamic Fund

As we know that the word Dynamic means something that can change and adapt to the changes.Dynamic Fund switches between Short term and Long term Debt instruments. These funds invest in almost all types of Debt and Money market instruments with different maturities. Dynamic Funds are better from a long-term investment perspective.

4. Gilt Funds

Gilt Funds invest in Government-backed securities. Now we know that since the securities are backed by the government of a country the chances of default are considered negligible. However, this fund is very sensitive towards the changes in interest rates and thus carries interest rate risk.

5. Overnight Fund

As the name suggests, Overnight Fund invests in the securities having a maturity period of only 1 Day. Now, since the time of investment is only 1 day, therefore Overnight Fund does not have any Default risk or Interest Rate risk associated with it. For example, suppose you invested in an Overnight Fund today, you will get the returns and your principal amount tomorrow itself.

6. Ultra-short duration Fund

These funds invest in fixed income-generating securities that have a maturity period between 3 to 6 months. These funds give similar or slightly higher returns than Bank’s Fixed Deposits. This is the safest Fund because of its very short duration of the investment.

7. Low Duration Fund

Low Duration Funds invests in securities that have a maturity period of 6 to 12 months. These funds have comparatively more risk as to Ultrashort duration fund because of an increase in the period of investment, and so are its returns.

8. Short Duration Fund

Short Duration Fund invests in debt securities that have a maturity period between 1 to 3 years.

9. Medium Duration Fund

Medium Duration Fund invest in debt securities that have a maturity period between 3-4 years.

10. Medium to Long Term Duration Fund

These funds invest in debt securities that have a maturity period between 4-7 years. This is comparatively riskier than other duration debt funds because of the time of investment but also can provide you with comparatively greater returns.

11. Long Duration Fund

These funds invest in debt securities that have a maturity of more than 7 years. These are generally not preferred by conservative investors as it has the highest risk compared to other duration funds.

12. Floater Fund

Floater Fund invests in debt securities that have a floating rate of interest i.e. the interest rates keep on changing based on the change in the interest rates in the markets, and so do the returns as it is the rate of interest that will define the interest that you will earn. So, when the interest rates in the market rise so do the returns from the floater fund, and when the interest rates fall, the returns from these funds also fall.

13. Credit Risk Fund

From the name itself, we can understand that these funds invest in securities that are rated below the highest quality of bonds by the credit rating agencies. Therefore, these funds have a certain amount of credit risk or default risk associated with it. And we know that since it has more risk, so it will have the capacity to provide you with high returns.

14. Corporate Bond Fund

These funds invest in the debt instruments issued by companies that are rated high by the credit rating agencies. Since they have a high credit rating so there are fewer chances that your money would be trapped and not returned to you with interests so it is comparatively safer and suitable for conservative investors.

Factors to consider by an investor before investing in debt funds

Risks

There are mainly two types of risk involved with Debt Mutual Funds. They are :

  1. Interest Rate Risk: Since Debt Mutual Funds invest in debt securities that give you return in terms of interests at a pre-decided interest rate. Therefore, a change in the prevailing interest rate in the market would hurt the value of these Funds. As the interest rate is inversely proportionate to the Net Asset Value(NAV) of Debt funds i.e. a rise in the interest rate would imply the fall in the NAV of the Debt Funds and vice versa.
  2. Credit Risk/ Default Risk: What if the issuer of the debt instrument goes bankrupt? What if he for some reason is not able to pay back your amount with returns? In this scenario, you might fail to receive the principal amount that you invested and the returns/interests that you were supposed to earn. This kind of risk is also associated with Debt Funds and is known as Credit/Default risk in which the issuer of the debt instruments fails to pay back the amount that you were supposed to get.

Return

As we know that debt instruments are considered as a safe investment so the returns generated by them cannot be compared to that of Equity Funds but can be greater than the returns of Bank Fixed deposits or Savings account. However, you should know that they don’t offer guaranteed returns i.e. there might be some ups and downs.

The Net Asset Value( NAV) of the Debt Mutual Fund depends on the Interest rates in the market. They have an inverse relationship. The NAV of the Fund would fall with a rising interest rate and would rise with the falling interest rates in the market.

Expense Ratio

Expense ratio is the amount that the Debt Fund Manager charges as a fee from you against the services provided by them. The expense ratio depends on the Asset Under Management(AUM) i.e. the total assets that the Mutual Fund holds which includes the total investments made in that Fund and the returns generated. The higher the AUM the lesser would be the expense ratio and vice versa. Therefore, you as an investor must select a fund that has a low expense ratio.

Taxation

There are two types of taxes in Mutual Funds:

  1. Short Term Capital Gain (STCG): If you are invested in Debt Mutual Funds for a period of up to 3 years and the returns earned by you within that period is Short Term Capital Gain (STCG). STCG is taxed according to the tax slab you fall into. For example, suppose you invested in a Debt Fund for 2 years and now you want to redeem your units, the tax slab that you fall into is 30%, then the returns earned by you will be STCG and will be taxed at 30%.
  2. Long Term Capital Gain (LTCG): If you are invested for more than 3 years of timeframe then the returns earned by you will be termed as Long Term Capital Gain (LTCG). LTCG is taxed at the rate of 20%.

Who should invest in Debt Mutual Fund?

Debt Mutual Funds are best suitable for Conservative Investors i.e. those investors who do not want to take much risk and want stable returns. These funds are also suitable who want to stay invested for the short to medium term. Short-term can range from 3 months to 1 year, and medium-term can range from 3 years to 5years. Though the returns here are not guaranteed as we have already come across the reason. There might be a few ups and downs in the returns.

Conclusion

If you are an investor who does not want to take much risk and are also satisfied with stable and small returns, Debt Mutual Funds is the place for you. As they invest in fixed income securities that are less risky compared to other Mutual Funds.

Though you should understand that in Debt Mutual Funds there are schemes that have different time horizons and risk-taking capability, so before investing you must know your investment goals, time horizon, and your risk profile to know the right Fund for you. In short, you should know how to select the Fund that is most suitable to you as an investor.

FAQ’s

What is Debt Mutual Fund?

Debt Mutual Funds invests your money in fixed income-generating securities like government securities, corporate bonds, debentures, and other money market instruments.

Is it good to invest in Debt mutual funds?

Debt mutual funds are most suitable for those investors who cannot tolerate much risk and for a short to medium-term investments. Since these funds invest in fixed income securities, therefore these funds are considered to be very less risky.

Are Debt Mutual Funds safe?

Debt Funds invest in fixed income securities. These are considered safe investments as compared to equity funds that are exposed to the high volatility of the markets. Though the returns generated by them are pretty less as compared to equity funds but with the matter of safety, there is no question that Debt funds are safer than equity funds.

Are the returns guaranteed in Debt Mutual Funds?

No, we should understand that Debt Funds mostly depend on the interest rate structure in the economy so when the interest rates in the market rise the value of the debt funds falls and vice versa. Therefore there might be certain ups and downs in the returns but not as much as Equity Funds because Debt Funds are less volatile than equity funds.

Why should you invest in Debt Mutual Funds?

The reason for investing in debt funds is to earn a stable interest income and capital appreciation.

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