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Debt Funds

Debt funds are a type of mutual funds that primarily invests in fixed-income securities such as bonds, government securities, corporate bonds, treasury bills, and other money market instruments. The main objective of debt funds is to provide regular income and capital preservation with relatively lower risk compared to equity funds.

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Benefits of Debt Funds

  • Provides regular income with less volatility than equity funds.
  • Adds balance to the investment portfolio, reducing overall risk.
  • Debt funds are more tax-efficient compared to traditional fixed deposits. If you stay invested for at least 3 years
  • Liquid funds are an excellent option for emergency funds. They invest in very short-term instruments and offer quick redemption, often within one business day, while typically providing higher returns than savings accounts.

 

Key Features of Debt Mutual Funds.


  1. Fixed-Income Investments: Debt funds invest in various fixed-income instruments, which pay a fixed rate of interest and return the principal amount at maturity. These include:
    • Government Bonds: Issued by the government and considered low-risk.
    • Corporate Bonds: Issued by companies, typically offering higher returns than government bonds but with slightly higher risk.
    • Treasury Bills: Short-term government securities with maturities of less than a year.
    • Commercial Paper: Short-term unsecured promissory notes issued by corporations.
    • Certificates of Deposit: Issued by banks with fixed interest rates and maturities.
  2. Lower Risk: Debt funds are generally considered safer investments compared to equity funds because they invest in instruments that provide regular interest payments and return the principal at maturity. However, they are not entirely risk-free and can be affected by interest rate changes and credit risk.
  3. Returns: Debt funds generate returns primarily through interest income from the fixed-income securities they hold. Additionally, capital gains can occur if the fund manager buys and sells securities at favorable prices. However, returns are typically lower than those of equity funds but more stable.
  4. Interest Rate Sensitivity: The value of debt funds can be affected by changes in interest rates. When interest rates rise, the prices of existing bonds usually fall, and vice versa. This interest rate risk can impact the fund’s performance.
  5. Tax Efficiency: Debt funds are more tax-efficient than fixed deposits. They offer indexation benefits for long-term capital gains, which can reduce the taxable amount.
  6. Professional Management: Like equity mutual funds, debt funds are managed by professional fund managers who select and manage the portfolio of fixed-income securities to achieve the fund’s objectives.

Who Should Invest in Debt Funds ?


  1. Conservative or First-Time Investors: If you're a conservative or first-time investor who wants to avoid the high risks of equity funds, invest in debt funds like short-duration funds or corporate bond funds are good options. They can replace bank fixed deposits, offering more liquidity, flexibility for withdrawals, and potentially higher returns, especially when interest rates are falling.
  2. Regular Income Seekers: Debt funds are ideal for those needing a steady income stream, such as retirees. These funds pay regular interest, providing reliable income while keeping your capital safe.
  3. Short- to Medium-Term Goals: If you have financial goals set for a few months to a few years, debt funds are a good fit. They balance safety and returns, making them suitable for short- to medium-term investments.
  4. Investors in Bearish Markets: Even if you're an aggressive equity investor, you can benefit from combining a debt fund with a Systematic Transfer Plan (STP). In a bearish or sideways market, an STP gradually moves money from a debt fund to an equity fund, reducing the average cost of equity investments.
  5. Portfolio Diversification: Adding debt funds to a portfolio that includes equities can help balance risk and provide more stable returns. Debt funds have lower volatility compared to equities, making them a useful tool for diversification.

How Do Debt Mutual Funds Work?


Debt funds are mutual funds that invest in fixed-income securities such as bonds, treasury bills, and other debt instruments. Here’s a simplified explanation of how they work and generate returns:

  1. Sources of Returns: Debt funds earn returns in two main ways:
    • Interest Income: The fund receives regular interest payments from the bonds it holds. This is called coupon or accrual income.
    • Capital Gains or Losses: When interest rates change, bond prices move in the opposite direction. If market yields rise, bond prices fall, leading to a decline in the fund’s value. Conversely, if market yields fall, bond prices rise, increasing the fund’s value. These changes in bond prices are called mark-to-market (MTM) returns.
  2. Capital Gains and Interest Earnings:
    • Average Maturity: The average maturity of the bonds in the fund affects capital gains. Long-term bonds are more sensitive to changes in interest rates. When market yields fall, long-term bonds increase in price more than short-term bonds, leading to higher capital gains. However, when market yields rise, long-term bonds decrease in price more significantly, leading to higher capital losses.
    • Interest Rate Risk: Funds with higher average maturity (or duration) carry higher interest rate risk, meaning their net asset values (NAVs) are more volatile with changes in interest rates.
    • Credit Rating: Bonds with lower credit ratings typically pay higher interest rates but come with higher default risk. Funds that invest in lower-rated bonds can increase yields through higher coupon payments but also face increased credit risk.
  3. Strategies to Manage Returns:
    • Maturity Profile: Fund managers can adjust the maturity profile of the bond portfolio to manage interest rate risk. Investing in long-term bonds can yield strong capital gains when interest rates are falling, but may result in significant losses when rates rise.
    • Credit Rating: Choosing bonds with higher credit ratings (e.g., AAA or AA+) ensures principal safety but may result in lower yields. Conversely, holding more lower-rated bonds can increase coupon income but also heightens credit risk.


Types of Debt Funds. 

Check out the different debt funds types available in India listed below! These debt mutual funds types cater to different investment preferences and financial objectives.

Overnight Fund

 An open-ended debt scheme investing in overnight securities with a 1-day maturity.

Ultra Short Duration Fund

An ultra-short term debt scheme investing in instruments with Macaulay duration of 3-6 months.

Liquid Fund

An open-ended liquid scheme investing in debt and money market securities with a maturity of up to 91 days.

Medium Duration Fund  

An open-ended debt scheme investing in instruments with a Macaulay duration of 3-4 years.

Medium to Long Duration Fund  

An open-ended medium-term debt scheme investing in instruments with Macaulay duration between 4 and 7 years.

Long Duration Fund  

An open-ended debt scheme investing in instruments with Macaulay duration over 7 years.

Low Duration Fund

An open-ended debt scheme with a duration of 6-12 months

Money Market Fund  

Debt scheme investing in short-term money market instruments with up to 1-year maturity.

Short Duration Fund  

An open-ended debt scheme investing in instruments with Macaulay duration of 1-3 years

Banking and PSU Fund

An open-ended debt scheme investing mainly in bank, public sector, and financial institution debt with at least 80% of total assets.

Floater Fund

Open-ended debt fund types scheme investing primarily in floating rate instruments with a minimum 65% allocation of total assets.

Dynamic Bond

An open ended dynamic debt scheme investing across duration.

Corporate Bond Fund

An open-ended debt scheme investing at least 80% of total assets in highest-rated corporate bonds.

Credit Risk Fund

An open-ended debt scheme investing in below highest rated corporate bonds with at least 65% in corporate bonds.

Gilt Fund

Open-ended debt scheme investing primarily in government securities across different maturities.

Gilt Fund with 10 year constant duration  

An open-ended debt scheme investing primarily in 10-year government securities to match a portfolio Macaulay duration of 10 years.