Debt Mutual Funds: Meaning, Types and Features

Want to park your money for the short term, or are you looking for relatively safe investment options other than equities? In most cases, investors look for bank FDs or savings accounts, but there are different investment options known as Debt Mutual Funds that can provide relatively higher returns than bank savings accounts and fixed deposits.

In this blog, we will learn about debt funds and their different types.

Overview – Debt Mutual Funds

Debt Mutual funds primarily invest in fixed-income assets such as treasury bills, bonds, government securities, and other debt instruments. All of these investments have a predetermined maturity date and coupon that an investor will receive upon maturity. These funds are professionally managed by asset management firms and are ideal for investors seeking a consistent return.

Debt funds provide diversification across a variety of debt instruments, assisting investors in risk management. If you want to learn more about debt mutual funds, check out our blog on the same: What are Debt Mutual Funds?

Features of a Debt Mutual Fund

1. Debt funds generally offer lower returns than equity-oriented funds because their portfolios are invested in fixed-income securities.
2. It diversifies your investment into numerous debt instruments, allowing you to obtain a consistent return, which is why they are popular among low-risk investors.
3. Most debt mutual funds have high liquidity and no exit load, allowing investors to withdraw their cash at any moment, depending on the current net asset value.

Types of Debt Funds

As per the Association of Mutual Funds in India (AMFI), there are 16 types of debt funds that cater to the needs of investors; let’s explore each one of them:

1. Liquid Funds—These funds invest in money market securities with a maximum maturity of 91 days. They could be a good alternative to a savings bank account.
2. Overnight Funds – The securities of overnight funds have a maturity of one day. These are regarded as the safest type of debt fund because credit and interest rate risk are minimal in such funds.
3. Ultrashort Duration Fund—This fund invests in money market instruments, with a Macaulay duration ranging from 3 to 6 months.
4. Short Duration Fund—This fund invests in debt instruments with maturities of 1 to 3 years. It generally earns higher returns than money market funds.
5. Money Market Funds – The portfolio of money market funds is invested into debt securities having maturity of up to 1 year.
6. Low Duration Funds- These funds invest in Debt & Money Market instruments with Macaulay duration ranging from 6 months to 12 months.
7. Medium Duration Fund – The medium duration fund invests in the maturity of debt securities, which ranges from 3 to 4 years.
8. Medium to Long Duration Fund—The portfolio of a medium to long duration fund holds securities maturing from 4 to 7 years.
9. Long Duration Fund – It invests in debt securities having a maturity of more than seven years.
10. Corporate Bonds Fund – This fund invests at least 80% of its total assets in AA+ or higher-rated corporate bonds. These bonds offer higher returns than government securities but also carry higher risk.
11. Banking & PSU Debt Fund – This fund’s portfolio consists of debt securities issued by public sector undertakings (PSUs) and banks, which constitute about 80% of its total portfolio.
12. Gilt Fund—It invests a minimum of 80% of its investible corpus in government securities across varying maturities. These funds have a very low credit risk; however, they carry interest rate risk.
13. Gilt Fund (10 Year) – These funds are similar to Gilt funds; the only difference is that they invest a minimum of 80% of corpus in government securities with a Macaulay duration of 10 years.
14. Dynamic Bond Fund – These funds don’t have any restrictions on the security type or maturity profile for the investment. They change their portfolio according to the market dynamics.
15. Floater Funds – This fund invests at least 65% of its total assets into floating-rate instruments (including fixed-rate instruments converted to floating-rate exposures using swaps/ derivatives). These funds carry less mark-to-market risk because the coupon of these floating-rate bonds is reset periodically based on the market rates.
16. Credit Risk Fund—This fund invests a minimum of 65% of its total assets into corporate bonds with a rating below AA. It tries to generate high yields compared to corporate bond funds. However, this fund carries high default risk, so investors in credit risk funds need to be cautious.

Risks in Debt Mutual Fund

Primarily, the credit risk and interest rate risk are two different types of risk associated with investing in debt mutual funds.

Credit Risk

Credit risk arises when the borrower fails to repay the principal and interest. An investor can analyze the bond ratings issued by credit rating organizations before investing. Generally, debt securities issued by the Government carry lower credit risk as compared to securities issued by Corporations.

Interest Rate Risk

There is an inverse relationship between Bond prices and interest rates. When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. It is because when interest rate rises, new bonds are issued at a higher interest rate, causing the value of existing bonds to fall, which negatively impacts the performance.

Taxation of Debt Fund

We have discussed multiple categories of Debt Mutual funds above. Taxation of debt mutual funds depends on the equity component of a fund, investment horizon, and individual tax slab.

The income tax regulations governing capital gains generated by debt mutual funds have recently changed (removal of indexation benefit).

If any debt mutual fund has less than 35% of the investments in equity, then gains from that will be taxed as per the income tax slab without any indexation benefit. Further, there will be no STCG and LTCG in this case..

However, if a debt mutual fund has 35 – 65% in equity or equity-oriented securities, then STCG or LTCG will apply:

Short-Term Capital Gain Tax (STCG): If you remain invested in a debt mutual fund for less than three years and have a capital gain, you will be taxed based on your income tax bracket, without any indexation benefit.
Long-Term Capital Gain Tax (LTCG): If you sell your investment after three years, it will be categorized as long-term capital gain and taxed at a rate of 20% with an indexation benefit.

If you’re curious to learn more about the taxation of mutual funds in India, check out our detailed blog on the same: Mutual Funds Taxation in India

Who should invest in Debt Mutual Funds?

Debt funds are a suitable for investors who want to meet short-term financial goals and are looking for Bank FD alternatives, because they are less volatile than equity mutual funds and provide stable returns. They are also an alternative for investors seeking a higher return than traditional fixed-income products and ready to accept a moderate amount of risk.

Did you know?

Bank FDs are insured to the extent of INR 5 lakhs by the Deposit Insurance and Credit Guarantee Corporation (DICGC). There is no such protection in debt mutual funds.

Conclusion

There is a wide selection of debt mutual funds available in the market, and choosing one can be challenging for an investor because each category has its own set of features, risks, and returns. As a result, investors should assess their risk profile and align their investment objectives properly before making any investment in debt mutual funds. Furthermore, it is always recommended that investors seek advice from financial advisors before making investing decisions.

Frequently Asked Questions (FAQs)