8 min read • Published 10 Feb 25
What are debt mutual funds?
Table of Contents
Introduction
Debt mutual funds are investment vehicles that allocate their assets primarily to fixed-income securities such as bonds, treasury bills, and money market instruments. These funds aim to provide investors with steady returns and relatively lower risk compared to equity investments.
Contrary to the common belief that debt instruments are entirely risk-free, they do carry certain risks, including credit risk, interest rate risk, and liquidity risk. Understanding the types of debt mutual funds and their risk-return characteristics is essential for selecting the most suitable option for long-term wealth creation. This overview will help clarify what debt mutual funds are and provide insights into their suitability based on individual investment objectives.
What is Debt Mutual Funds?
Debt mutual funds are investment funds that primarily invest in fixed-income securities like bonds, treasury bills, and other money market instruments to provide stable returns with lower risk compared to equity funds. Such funds help people secure their capital due to their lower risk profile and provide stable growth until maturity.
These funds give investors small returns but have more financial stability and don’t change much when the market goes up and down. Debt funds often appeal to investors who don’t like taking risks.
How does a Debt Mutual Fund work?
Debt funds invest in debt instruments that are both listed and unlisted. They purchase these instruments and then sell them at higher prices also getting interest along the way. Bond prices change with the economy’s interest rates. The central bank bonds rise or fall when it raises, or cuts, interest rates. Every year, this change in price, up or down, is added to the debt funds’ NAVs. The yearly interest these instruments receive is divided by 365, and that amount shows up in the NAV at the end of each day.
Investors also have a choice of debt instruments that do not fluctuate with interest rates, with their value remaining the same as fixed deposits. Returns on debt instruments depend upon the credit ratings they receive from reputed credit agencies. Government bonds are the safest kind as they are backed by the government and command the highest rating (AAA or AA) and lowest rate of interest. Corporate bonds are rated slightly lower than government bonds but offer high interest rates.
Benefits of Debt Mutual Funds
Following are the benefits of choosing debt mutual funds:
- Regular income: Debt instruments provide regular income to the investors. Although the value of the bond can fluctuate, the coupon payment will remain fixed. The coupon payment, though not received by investors directly, is added in NAV. This gives investors assured returns even during adverse market conditions.
- Low risk: These funds bear much lower downside risk as compared to other assets such as stocks. They are also much less volatile. Debt mutual funds are best for risk-averse investors.
- Diversification: Adding debt funds to a portfolio helps reduce risk. When the stock markets slump central banks reduce interest rates, which raises the value on debt instruments.
- Accessibility: High price tags of the debt instruments makes them too costly for individual investors to buy. A debt mutual fund, however, allows an investor to put money into a spectrum of interest bearing securities, many of them inaccessible in the past.
- Liquidity: The debt instruments markets have very high turnover and volumes. This is a highly liquid market. If an investor wants to cash out a big position they easily can without much slippage.
- Professional management: Experts who know the ins and outs of debt markets run debt mutual funds. This saves investors the trouble of picking the best debt instruments themselves.
Types of Debt Mutual Funds
Securities and Exchange board of India (SEBI) has classified debt mutual funds into 16 categories:
| TYPE OF FUND | FEATURES |
| Overnight fund | Securities with 1 day maturity |
| Liquid fund | Securities with 91 days maturity |
| Ultra short duration fund | Portfolio macaulay duration of 3 to 6 months |
| Low duration fund | Portfolio with macaulay duration of 6 to 12 months |
| Money market fund | Securities with maturity up to 1 year |
| Short duration fund | Portfolio macaulay duration is 1 to 3 years |
| Medium duration fund | Portfolio macaulay duration is 3 to 4 years |
| Medium to long duration fund | Portfolio macaulay duration is 4 to 7 years |
| Long duration fund | Portfolio macaulay duration is more than 7 years |
| Dynamic bond fund | Invest funds across various maturity duration bonds |
| Corporate bond fund | Minimum 80% investment in corporate bonds |
| Credit risk fund | Minimum 65% investment in corporate bonds |
| Banking and PSU fund | Minimum 80% investment in Banks and PSU bonds |
| Gilt funds | Minimum 80% investment in government bonds (across maturities) |
| Gilt fund with 10y constant duration | Minimum 80% investment in government bonds +Macaulay duration of 10 years |
| Floater fund | Minimum 65% investment in floating debt instruments |
Source: SEBI
Who Should Invest in Debt Funds?
Debt mutual funds suit investors who don’t like risk and want to avoid volatile assets. These funds also work well for investors looking for steady income, as the interest from debt assets keeps adding to the NAV. Equity investors should also put some of their money into debt mutual funds for safety when stock markets crash.
Risks Associated with Debt Mutual Funds
- Credit risk: Investors face trouble when debt issuers don’t pay back the principal. Take a company that puts out a bond and goes broke. Its bond investors end up with losses. Mutual funds might pick low-quality bonds to get higher returns, which ups the risk.
- Interest rate risk: Changes in interest rates can make the NAV of debt mutual funds go up and down. When interest rates climb, bond values drop, and the other way around.
- Inflation risk: After accounting for inflation, the bonds have very low real returns. Sometimes, the returns can not even beat inflation during a high inflationary period meaning investors are having net losses in inflation-adjusted terms.
Debt Mutual Funds Taxation
The debt mutual fund schemes purchased on or after April 1, 2023, will not qualify for indexation as stated by the Government. Any income from mutual debt fund investments made post this date will be taxed at the same rate as an individual’s tax percentage upon selling it, irrespective of the holding period.
Summary
An investor might want to consider investing their money in debt mutual funds whether they want to play it safe or just slow down a bit with that risk. These funds provide stability and steady income. An investor can pick a fund that suits their risk-return needs. Thorough research must be done before choosing any debt mutual fund.
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Disclaimer: The information provided is for informational purposes only. PowerUp is not responsible for any errors, omissions, or outcomes related to using this information.
Q: How safe are debt mutual funds?
Debt and debt funds are considered least risky among all asset classes. There’s some risk but it is extremely small relative to stocks, commodities etc. Investors who want stability and a source of income free from much volatility should be the ones who delve into this.
Q: How are returns calculated in debt mutual funds?
Returns are calculated using price changes and coupon payments. Prices of bonds change or fluctuate due to changes in interest rates. The annual interest earned by a bond keeps on adding to the NAV on a daily basis.
Q: How do interest rates affect debt instruments?
When the central bank increases interest rates, the price of bonds conventionally goes down. When the rates are decreased, the value of bonds increases. This is done in order to keep the coupon payment constant in value. Prices of bonds are also factored by supply-demand related factors.
Q: What are junk bonds?
Junk bonds are names given to the corporate bonds which have low credit ratings. These are often bonds of firms that are highly likely to be in default. These companies use high interest to invite investors thus expand their capital base. Some debt fund portfolios are invested in junk bonds by investors to get high returns.
Q: What is the difference between FD and Debt funds?
A fixed deposit is a type of bank account which earns a fixed amount of interest where an individual can park a certain quantity of money for a specified time period. While investing in bonds, debt funds are different because debt instruments are affected by price fluctuation.
