Generally, one of the primary investment rules is not to place all the eggs in the same basket. Therefore, one should have a balanced investment portfolio that includes ‘High Risk – High Returns’ and ‘Low Risk – Low Returns’ assets. In mutual fund language, you can say that an ideal mix of equity funds and debt funds should form part of your balanced investment portfolio.
Let us see what debt funds are and how they compare with equity funds. Besides, we shall also discuss the various debt fund types in India.
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What are debt funds?
Debt funds invest in fixed-income securities, including government securities, treasury bills, commercial papers, corporate bonds, etc. All these safe instruments have a pre-decided maturity and interest rate. Hence, debt funds are also known as ‘Low Risk – Low Returns’ investments.
Here is how debt funds work.
Every debt security has a credit rating allowing investors to ascertain the possibility of default in principal and interest repayment. A higher rating makes the instrument safer. Debt fund managers refer to these ratings to invest in high-quality investments.
So, does it entail that debt fund managers do not invest in low-quality assets?
It does not work that way. Debt fund managers also choose low-quality instruments by taking calculated risks that enable them to earn higher returns. However, a stable debt fund has a higher proportion of high-quality securities in its portfolio.
Who can invest in debt funds?
Technically, anyone can invest in debt funds. However, people with a low-risk tolerance level prefer debt funds, whereas those capable of withstanding high risks opt for equity funds.
- Short-term debt funds are ideal for investors looking for better instruments than regular bank savings accounts. These funds give 7% to 9% good returns without compromising liquidity.
- Medium-term investors who generally prefer bank FDs can also invest in debt funds that offer better returns than FDs. Monthly payout plans are also available for such investors
Different debt funds types in India
Here are the various debt fund types in India based on the maturity period.
- Liquid Fund – These short-term debt funds are better than regular bank savings accounts because they give better returns than short-term investments. The Liquid Funds invest in market instruments with maturity periods of a maximum of 91 days.
- Money Market Fund – Investors looking for low-risk gains can invest in the Money Market funds that invest in money market instruments with a maximum maturity of one year.
- Dynamic Bond Fund – Investors with moderate risk-tolerance levels can invest in the Dynamic Bond Fund. These funds invest in debt instruments of different maturities, depending on the interest rate structure. The investment period is between three to five years.
- Corporate Bond Fund – Investors with low-risk tolerance wanting to invest in high-quality corporate bonds can invest in the Corporate Bond Fund. It invests 80% of its corpus in corporate bonds with the highest ratings.
- Banking and PSU Fund – This fund invests around 80% of its total assets in the debt securities of PSUs and banks.
- Gilt Fund – These funds have the highest interest rate risk but are the safest because they invest 80% of their assets in government securities.
- Credit Risk Fund – These funds invest 65% of their corpus in corporate bonds having credit ratings below the highest-quality bonds. Therefore, there is an element of credit risk, but they offer better returns than the highest-quality bonds.
- Floater Fund – This fund invests 65% of its assets in floating rate instruments. Hence, they carry a low-interest rate risk.
- Overnight Fund – These funds do not have any credit risk and negligible interest rate risk because they invest in debt securities having a maturity of one day.
- Ultra-Short Duration Fund – This debt fund invests in money market instruments and debt securities, ensuring that the Macaulay duration of the plan is between three and six months.
- Low-Duration Fund – It is a variation of the Ultra-Short Duration Fund, but the Macaulay duration is six and twelve months.
- Short-Duration Fund – It invests in money market instruments and securities, ensuring the Macaulay duration between one and three years.
- Medium Duration Fund – It is a similar fund, except that the Macaulay duration is three and four years.
- Medium to Long Duration Fund – The Macaulay duration is four to seven years.
- Long Duration Fund – This fund invests in money market instruments and debt securities with a Macaulay duration of more than seven years.
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Equity vs. Debt Funds
Let us compare equity and debt funds to understand their significance. We recommend investors have a balanced portfolio of equity and debt funds. Therefore, let us look at the equity vs. debt funds.
- Risk – Equity funds are susceptible to market fluctuations. Hence, they carry a higher risk than debt funds that invest in fixed-income securities.
- Taxation – Equity funds are subject to short (less than 12M) and long-term capital gains tax. The STCG is 15%, whereas the LTCG has an exception of Rs 1 lakh, Mid-cap, and the balance is taxed at 10%. Debt funds held up to 36M are taxed per the IT slab, whereas LTCG is 20%.
- Tax Saving Options – Equity funds allow for tax savings up to Rs 1.50 lakhs.
- Expense Ratio – Both equity and debt funds have fund managers. Hence, there is an expense ratio attached to both these funds.
Compared to equity funds, debt funds offer lower returns
Risks that Debt funds carry
Debt funds carry the following three types of risks.
- Interest Rate Risk – If the Government or the RBI changes the interest rates, the returns are affected.
- Credit Risk arises when the issuer does not repay the principal and interest amount.
- Liquidity Risk – If the fund house does not have adequate liquidity to run the fund, there can be a liquidity risk.
We have discussed the debt funds concept and compared equity vs. debt funds. Besides, we have discussed the different debt fund types available in India. We trust that this information should prove helpful.