What Are Debt Funds, Types, Benefits? (2024)

Debt mutual fund is the biggest mutual fund category, as there are 14 different sub-categories of debt funds. It invests in debt securities and earns through capital appreciation and interest. It aims to deliver an inflation-beating return. They are less volatile and less risky, making them suitable for conservative investors looking for the safety of capital without much volatility.

In this blog, we’ll understand what debt funds are, their benefits and types, how they work, and who should invest in them.

What is a Debt Fund?

Debt fund is a type of mutual fund scheme that invests in fixed-income instruments like corporate bonds and government bonds, corporate debt securities, money market instruments, etc. These funds are professionally managed by asset management companies (AMCs) and are well-suited for investors seeking a relatively stable and predictable source of income. Debt funds offer diversification across a range of debt instruments, which helps mitigate risk, and they are known for their liquidity, allowing investors to buy and sell units easily.

The returns from debt funds are generated through interest income and capital appreciation, and their taxation depends on the holding period, making them a versatile choice for various investment goals and risk profiles. These funds are also known as income funds or bond funds.

How Debt Funds Work?

Debt funds invest your money in various debt instruments, such as corporate or government bonds. They invest in these instruments at lower cost and sell them later on margin in the future. The difference between the buying and selling price of the instrument increases or decreases the NAV of the fund.

If the selling prices are higher than the buying price, it results in appreciation in NAV; however, if it is lower, it leads to depreciation in NAV.

As they invest in debt instruments, they regularly receive interest, similar to Bank FDs. These interest incomes are added to the fund, increasing its NAV.

NAV of the debt funds also gets influenced by the interest rate of the underlying assets and their credit rating. As interest rates change in the market, the price of a bond also changes.

For example, if the market interest rates go down, it usually means new bonds will have lower annual interest rates. Let’s take an example to understand this:

Assume your fund has invested in a debt instrument offering an annual interest rate of 8%. But now, after a fall in the market interest rate, they might be issued with 6% annual interest. This change may increase the price of the 8% bonds to match the return of lower interest rate bonds. As a result, when the bond price increases, it increases the NAV of the fund.

Who should invest in Debt Mutual Funds?

Whether you should invest in debt funds or not depends on various factors like your financial goals and risk tolerance, among others. They are suitable for:

Short-Term Goals

If you have short-term goals like buying a car and planning a vacation, among others, then a debt fund is an ideal option for you as they are less volatile and can give a better return in the short term.

Earning higher returns than traditional instruments

If you’ve been investing your money in conventional fixed-income instruments such as term deposits and want to earn higher interest by taking some moderate level of risk, then debt mutual funds are the best option for you.

Types of Debt Funds

There are different types of debt funds to suit investors with varying risk-return profiles, investment horizons, and financial goals which are as follows:

Overnight Funds

Overnight Funds invest in securities having a maturity of 1 day, typically money market instruments. These funds aim to provide liquidity and convenience, rather than high returns. They are suitable for investors (mainly corporate treasuries) looking to park funds for a very short period.

Liquid Funds

Liquid funds invest in debt securities with less than 91 days to maturity. They are suitable for investors who want to park temporary cash surpluses for a few days, as they provide steady returns with minimum NAV volatility.

Ultra-short Duration Funds

These funds are suitable for investors with an investment horizon of at least 3 months. These funds earn slightly higher yields than liquid funds and are considered low-risk investments. Some ultra-short-duration funds may invest in lower-rated bonds to push up their yields.

Low-Duration Funds

These funds are moderately risky and provide reasonable returns. They are useful for those looking to invest for around 6 months to one year. Their portfolio may include bonds with a weaker credit rating to kick up yields.

Money Market Funds

Money market funds invest in debt instruments with a maturity of up to one year. They aim to generate returns from interest income, while their slightly longer duration offers some scope for capital gains.

Short-Duration Funds

Short-duration funds invest in a judicious combination of short and long-term debt, as well as across credit ratings. These funds are recommended for investment horizons of 1-3 years. They usually earn higher returns than liquid and ultra-short duration funds but also show more NAV fluctuations.

Medium, Medium to Long, and Long Duration Funds

Under normal situations, the portfolio duration of amedium-duration fundhas to be between 3-4 years,medium-to-long duration fundsbetween 4-7 years, andlong-duration fundsgreater than 7 years. These funds invest in short and long-term debt securities of the Government, public sector, and private sector companies. They tend to do well when interest rates are falling but underperform when rates are rising. Thus, they carry fairly high interest rate risk.

Fixed Maturity Plans (FMPs)

These are closed-end funds that invest in debt securities with maturities that match the term of the scheme. FMPs typically invest in low-risk, highly-rated debt and hold passively until maturity, when the securities are redeemed and paid out to investors. The main advantage is that the FMP structure eliminates interest rate risk and enables investors to lock in interest rates. The main drawback is that though FMPs are listed, liquidity tends to be low.

Corporate Bond Funds

Corporate bond funds invest at least 80% of the portfolio in AA+ or higher-rated corporate bonds. Such funds are appropriate for risk-averse investors looking for regular income and the safety of the principal.

Credit Risk Funds

These funds invest a minimum of 65% of total assets in corporate bonds rated AA or below. That is why they usually generate higher yields as compared to the more conservative corporate bond funds. Investors who are willing to take on higher default risk may consider investing in credit-risk funds.

Banking and PSU Funds

These funds invest at least 80% of total assets in debt instruments issued by banks, PSUs, and public financial institutions. This is a moderate-risk product that seeks to balance yield, safety, and liquidity.

Gilt Funds

Gilt funds invest in government securities of varying maturities. They can be short or long-duration funds, depending on the maturity of their portfolio. Gilt funds have zero default risk because they invest in safe g-secs.

Floater Funds

Floater funds invest at least 65% of their assets in floating-rate bonds. These funds carry less MTM risk because the coupons on their floating-rate debt holdings are reset periodically based on market rates.

Dynamic Funds

These funds have no restrictions on security type or maturity profiles for investment. The best-performing dynamic funds manage their portfolios dynamically and flexibly according to market situations.

Why invest in debt funds?

Debt funds offer many benefits, especially to retail investors, or to investors who have traditionally kept their money in bank deposits.

Access to Professional Expertise and Market Returns

Investing in a debt fund offers the opportunity to earn interest as well as capital gains from debt. It allows retail investors to access money markets or wholesale debt markets- segments in which they cannot directly invest.

Low Portfolio Risk

Since debt funds are less risky than equity funds, a strategic allocation to the best-performing debt funds reduces risk and brings stability to an investment portfolio. Tactical investments in debt funds are useful to take advantage of temporary yield opportunities.

Range of investment options

Debt funds are available along the entire spectrum of maturity and credit risk. Shorter-duration funds generate regular and stable income. Longer duration funds earn from interest income as well as capital gains and suit investors who can take on higher NAV volatility. Overnight funds, liquid funds, corporate bond funds, and low-duration funds tend to invest in the safest debt products. Ultra-short and short-duration funds may be structured to take on credit risk to provide higher returns.

Liquidity

Debt funds are very liquid and can be redeemed easily, usually within one or two working days of placing the redemption request. Unlike bank fixed deposits or recurring deposits, there is no lock-in period. While a few funds may impose a small exit load for early withdrawal, in general, there are no penalties when a mutual fund investment is withdrawn.

Low-Cost Investment

According to the SEBI norms, the total expense ratio of a debt fund cannot exceed 2% of Assets under Management. Among debt funds, overnight and liquid funds have very low expense ratios, while dynamic and long-term funds charge higher expense ratios.

Top Performing Debt Mutual Funds

Taxation on Debt Funds

As per the latest income tax rules, LTCG and STCG arising from mutual funds are now taxed as per your income tax slab. There will be no indexation benefit in debt funds. This applies to the investment made after April 1, 2023

However, if investments are made before April 1, 2023, then taxability is different. Let’s understand about this in detail:

Short-Term Capital Gain

If you remain invested in debt mutual funds for up to 3 years and have made any capital gains by redemption, then it is considered as STCG or short-term capital gain. These gains are added to your income and taxed per your income slab.

Long-term Capital Gain

If you have invested for over 3 years and earned any gain, then it is classified as LTCG or long-term capital gain. These gains are taxed at a flat rate of 20% with indexation benefits.

How Debt Dunds Different From Equity Mutual Funds?

Equity mutual funds invest in companies by buying their stocks. So when you invest in them, you become part-owner of the company the fund puts money in.

The returns equity funds are generated through a combination of selling a stock at a higher price and the dividend received from the company. So the returns you get are dependent on the performance of the company. If the company does well, the price of stock increases as more people want to own it, plus the company might share the profits with shareholders via dividends. If it doesn’t do well, you might lose money. So the risk is higher, but so are the rewards.

On the other hand, debt funds lend to corporates. When you invest in them, you become a lender to these companies, not owners. The returns are generated by the interest received and the price appreciation of the Bond. For this reason, the performance of the company doesn’t have much impact on the returns – as long as it doesn’t default, you will get returns. However, the returns will not be as high as Equity Funds.

Debt Mutual Funds Risks

There are two risks associated with Debt Mutual Funds – Credit Risk and Interest Rate Risk. Let’s see what they are and how you can minimize them.

Interest Rate Risk

As mentioned earlier, the price of bonds rises and falls based on the interest rates in the economy, and that is the first risk associated with debt funds.

The price of the Bond increases because its interest rates go down. But what if the interest rates in the market go up? New bonds will give a higher interest rate, and hence the existing Bond’s value will go down (due to low demand). Subsequently, the NAV of the fund will fall.

Since it is not possible to predict how interest rates will move, the best way to mitigate this riskwould be to invest in those fund categories that lend for short-duration to medium-duration periods. That’s because interest rates don’t change drastically in a short period.

Credit Risk

The other risk is that the borrower defaults and doesn’t pay interest and/or principal amount back.

This risk played out sometime back when DHFL and IL&FS defaulted. The bonds issued became zero value, and mutual fund investors had to take a hit because of this.

The best way to avoid this risk is to invest in a debt fund that lends to highly rated corporates. Ratings assigned by credit agencies like CRISIL are a good indicator of the financial health of these companies. AAA rating indicates the lowest credit risk.

One thing worth noting is that since high-rated borrowers are less risky, they also give you lower interest rates.

Investment Strategies of Debt Mutual Funds

Debt Mutual Funds primarily follow two strategies to generate returns – an Accrual Strategy or a Duration Strategy. While these two strategies are quite different, few funds use only one of these strategies to generate returns. Most Debt Funds actually use a combination of these two strategies to maximize their returns.

Accrual Strategy

The Accrual Strategy of Debt Funds aims to generate consistent returns for the investor by investing in Bonds and holding them till maturity. This strategy focuses on receiving interest income from the Bonds it invests in. As a result of holding investments till maturity, the interest rate risk of these Debt Funds is quite low. This strategy is primarily used by Liquid Funds, Ultra Short Duration Funds, Low Duration Funds, and Money Market Funds. Debt Funds that follow this strategy are an ideal investment if you are seeking consistent returns with limited risk.

Duration Strategy

Debt Funds using the Duration Strategy focus on generating returns by actively buying and selling Bonds based on interest rate movement predictions. Debt investments following this strategy usually make a profit when Interest Rates fall leading to an increase in the price of Bonds as mentioned in the earlier example. The Duration Strategy is usually followed by Long Duration Funds, Dynamic Bond Funds, and Gilt Funds.

Mutual Funds that use a Duration Strategy have significant interest rate risk i.e. the fund might incur a loss if the interest rates start moving upwards instead of downwards. In order to mitigate this risk, these Debt Funds often invest in shorter-duration Bonds when an Interest Rate increase is predicted. On the other hand, longer-duration Bonds are preferred by these schemes when a decrease in Interest Rates is predicted.

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