Understanding Debt Mutual Funds: Types, Benefits And Returns

When it comes to investing, most people immediately think of the stock market. While stocks offer the potential for high returns, they also come with significant risks. On the other hand, traditional options like fixed deposits (FDs) provide stability but often fail to beat inflation. So, what’s the middle ground?

This is where debt funds come in. If you are wondering, what is a debt fund? It’s a type of debt-oriented mutual fund that invests in fixed-income securities like government bonds, corporate bonds, treasury bills, and other low-risk instruments. These funds aim to provide stable returns with lower risk compared to equities, making them a smart debt investment option for conservative investors.

How to invest in debt funds? The process is simple—you can choose from various categories based on your risk tolerance and investment horizon. In fact, over 200 debt mutual funds have delivered higher returns than bank FDs, proving that you do not need to compromise between safety and returns¹. 

To know more about this amazing investment avenue, read this article till the end. It will cover the types, benefits, and returns of debt mutual funds in detail.

Types Of Debt Mutual Funds

There are various kinds of debt mutual funds. They are explained as follows:

1. Money Market Funds

These funds invest in short-term debt securities with a maximum maturity of one year. They are ideal for conservative investors seeking stability and low risk.

2. Short-Term Debt Funds

Short-term debt funds invest in securities with maturities of 1 to 3 years, offering relatively stable returns with low risk and high liquidity.

3. Long-Term Debt Funds

These funds focus on debt securities with maturities ranging from 4 to 6 years. They are suitable for investors seeking higher returns over an extended period.

4. Dynamic Bond Funds

Dynamic bond funds actively adjust their portfolio by varying the duration and maturity of bonds. They include a mix of short, medium, and long-term bonds but are subject to market fluctuations.

5. Corporate Bond Funds

These funds allocate at least 80% of their portfolio to high-rated corporate bonds. They offer higher returns than government securities but come with slightly higher risk.

6. Gilt Funds

Gilt funds invest exclusively in government securities with no credit risk, making them a safe option for risk-averse investors. However, they are sensitive to interest rate movements.

7. Credit Risk Funds

Credit risk funds invest at least 65% of their assets in lower-rated debt instruments (below AA+ ratings) to earn higher yields. These funds carry a higher risk due to the possibility of default by issuers, making them suitable for investors willing to accept greater credit exposure for potentially higher returns.

8. Overnight Funds

Overnight funds invest in securities with a maturity of just one day. They offer the lowest risk and are ideal for investors looking for ultra-short-term parking of surplus cash.

9. Liquid Funds

Liquid funds invest in highly liquid short-term instruments with maturities of up to 91 days. They provide quick access to funds while earning better returns than a savings account.

Benefits Of Investing In Debt Mutual Funds

Investing in debt funds has numerous benefits. Some of them are:

A. High On Liquidity

Debt funds generally do not come with a lock-in period that prevents you from utilising them. This is the reason why these funds are more popular than bonds, as investors feel comfortable knowing that the money is accessible.

B. Relatively Stable And Safe

Investing wisely requires assessing risk and reliability. When chosen carefully, liquid debt funds can offer a safer and more stable option than many other investment avenues, providing both security and liquidity for short-term financial goals.

This will help you get an idea of whether that particular fund’s strategies align with your risk appetite. To further add to the stability factor, you must know that debt funds majorly invest in bond markets that are less prone to volatility than equity markets.

C. Capital Gains Tax

Liquid mutual funds provide numerous tax advantages through capital gain tax benefits. As per Section 112 of the Indian Income Tax Act, long-term investments get an indexation advantage of up to 20%, which reduces the overall taxable amount. This makes them more tax efficient in comparison to fixed deposits, helping investors gain more returns.

Overall, debt mutual funds offer stable returns with the benefit of high liquidity. You can achieve similar stable returns by directly investing in fixed-income securities like corporate bonds and securitised debt instruments on Grip Invest. This helps you save on expense ratio costs. Click the link below to explore live corporate bonds and SDIs offering fixed returns of up to 14%.

Who Should Invest In Debt Mutual Funds 

If you still are not sure whether you should invest in debt mutual funds or not, then stick with us.  We have curated a list of investors who may benefit from investing in debt mutual funds:

1. Conservative Investors: Investors who seek stability and lower risks should consider investing in debt mutual funds. It would be a great fit for such investors because these funds generally have lower fluctuations than equities.

2. Income-seeking Investors: Debt mutual funds can provide a regular income stream through consistent returns through interest payouts. Thus, such funds are considered suitable for retired individuals or people looking to have a passive source of income.

3. Tax-Conscious Investors: If you are someone who does not want your profit gains to be minimised due to taxes, you should consider investing in debt mutual funds. This is so because these funds offer substantial tax benefits in the long run.

4. Diversification Seekers: Debt funds invest in a variety of debt securities, helping to enhance portfolio stability and reduce overall risk. 

Key Considerations Before Investing 

Although there are numerous benefits of investing in debt mutual funds, it also comes with a certain level of risk. However, its risk factors can be minimised by keeping the following things into consideration before investing: 

1. Interest rate risk

Prices of fixed-income securities are inversely related to interest rate changes. If the interest rate goes up, the price decreases and vice versa. Hence, the longer the duration of a fund, the higher the sensitivity to interest rate changes. 

2. Credit risk

Credit risk refers to the risk of default, i.e. failure to pay interest or the principal by the issuer of the debt instrument. If the credit rating of an instrument reduces, the price of the fund is likely to fall. Likewise, if the credit rating gets upgraded, the price will rise.

3. Returns And Risks

Debt funds have always been considered less risky compared to equity funds; however, they carry their own risk. A debt fund's return may be affected by credit risk, interest rate movements, and liquidity risk. Thus, it is vital to make proper debt investment decisions by considering all these factors in play.

4. Fund History

You must prioritise fund houses with a promising history of sustained performance over at least five to ten years. Investing in such a reputed debt fund would minimise the risk that comes along with such funds.

5. Expense Ratio

Assess how much of your investment covers fund management expenses. Ideally, you must opt for lower expense ratios as they provide higher take-home returns, especially when comparing funds with similar asset allocations and returns.

6. Financial Ratios

To evaluate funds, you must utilise metrics like standard deviation, Sharpe ratio, alpha, and beta. It will help you get a better idea of the kind of risk you would be taking by investing in a particular debt mutual fund. Higher standard deviation and beta indicate increased risk compared to lower counterparts. Prefer funds with higher Sharpe ratios, signalling enhanced returns per unit of risk undertaken.

Conclusion 

Debt mutual funds are a balanced investment approach, providing stability, liquidity, and predictable returns. In fact, it can play a crucial role in helping you diversify your investment portfolio. However, recognising the varieties of available debt mutual funds, advantages, and risk parameters is critical for you to make significant financial choices. To learn more about investing in fixed-income opportunities like corporate bonds and SDIs, sign up on Grip Invest today.

Frequently Asked Questions On Debt Mutual Funds

1. What is the minimum investment requirement in debt mutual funds? 

According to SEBI, an investment for debt mutual funds requires a minimum investment of INR 100 for lump sum investment and a minimum investment of INR 500 for SIP. However, some mutual funds may require a high minimum investment.

2. How are debt mutual funds taxed?

From April 1, 2023, indexation benefits for long-term capital gains were removed. Now, both long-term and short-term gains are taxed according to the investor's income tax slab. 

3. Do Debt Mutual Funds provide returns during a market downturn?

Yes, debt mutual funds can offer returns during a market downturn, the reason being they invest in fixed-income securities such as bonds. These are usually less volatile than equity. However, factors such as changes in interest rates and credit risk can affect their performance.

4. How can I choose the best Debt Mutual Fund for my needs?

In order to choose a proper Debt Mutual Fund, you should consider the time you want to invest, the level of risk you are willing to take, and your financial targets. You should also assess the credit quality of the fund, the duration, the past performance of the fund and the expense ratio. To make an informed decision, align these with your objectives.  

5. What are the liquidity options available in debt mutual funds?

Debt Mutual Funds, for the most part, provide fairly good liquidity. Some provide easy access to your money. These funds can give you access to your money in as little as 24 hours. Some other corporate debt funds may require a period of a few days. You should watch for any exit loads or penalties for early withdrawals.

References

1. Economic Times, accessed from: https://economictimes.indiatimes.com/mf/analysis/over-200-debt-mutual-funds-gave-higher-returns-than-bank-fds-time-to-break-your-deposits/articleshow/117041472.cms?from=mdr

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