Mutual funds have become one of the most sought-after investment vehicles in recent years. They offer the flexibility to invest according to your financial goals and risk appetite. For instance, if you aim for high returns and are willing to take on more risk, equity mutual funds might be the right choice. On the other hand, if preserving your capital is a higher priority than earning high returns, debt mutual funds could be the ideal option.
While debt mutual funds may not promise exponential growth, they are known for their stability and lower risk. This blog will guide you through everything you need to know about debt mutual funds, including their definition, types, advantages, how they work, and how you can start investing in them. Keep reading.
What Are Debt Mutual Funds?
Debt mutual funds are investment vehicles that primarily invest in fixed-income securities, such as government bonds, corporate bonds, treasury bills, and other money market instruments. These instruments have pre-determined maturity dates and provide fixed returns on maturity.Â
Debt mutual funds aim to generate steady and predictable returns while preserving the capital invested. Unlike equity mutual funds, which are subject to market volatility, debt mutual funds are generally considered safer because they focus on fixed-income assets.
Debt mutual funds are suitable for investors with a low-risk tolerance who prefer stability over high returns. They are also suitable for short-term financial goals or situations where liquidity and safety are paramount.
How Do Debt Mutual Funds Work?
Debt mutual funds pool money from various investors and invest it in a diversified portfolio of debt instruments. The fund manager’s role is to optimise returns while managing the risks associated with these investments.
The primary source of returns for debt mutual funds is the interest earned on the underlying debt instruments. In addition to interest, these funds can also benefit from price changes in the debt securities. For example, when interest rates fall, the value of existing bonds increases, leading to capital gains for the fund.
Key Features of Debt Mutual Funds
Now that you know what is mutual funds, let’s discuss the key features of debt funds:
Stable Returns
Debt mutual funds invest in various fixed-income instruments to generate stable returns. Although the returns are not guaranteed, they are usually within the expected range. However, they are often lower than those of equity mutual funds.
Capital Safety
One advantage of debt mutual funds is that they offer capital safety. Their performance is not affected by market volatility.
Lower Risk
Debt mutual funds are less risky than their equity counterparts. However, they carry three fundamental risks – credit or default risk, interest rate risk, and liquidity risk. Changes in interest rates or defaults may impact the performance of debt mutual funds.
Pre-determined Maturity
Debt mutual funds primarily invest in fixed-income instruments with pre-determined maturity dates. After the maturity date, the asset management company (AMC) repays the principal to investors.
High Liquidity
Debt mutual funds usually offer high liquidity to investors. They can buy or redeem their funds anytime at the prevailing Net Asset Value (NAV). However, the liquidity may vary depending on the type of debt mutual fund.
Taxation
Returns from debt mutual funds are taxed depending on the holding period. If held for less than three years, the returns are added to the investor’s taxable income and taxed according to the applicable income tax slab rate. If held for more than three years, returns are taxed at a flat 20% rate with indexation benefits.
Types of Debt Mutual Funds
Debt mutual funds come in different types, catering to various investment goals and timeframes. Below are the different types of debt funds:
Liquid fundsÂ
These funds invest in short-term debt instruments with maturity periods of up to 91 days. They are ideal for parking surplus cash and earning better returns than a savings account.
Money Market Funds
These funds invest in money market instruments with maturity periods of up to one year. They are suitable for investors with short investment horizons.
Short-Term Funds
These funds invest in debt instruments with maturity periods of one to three years and are suitable for short-term financial goals.
Ultra-Short-Term Funds
These funds invest in debt instruments with very short maturity periods, ranging from three to six months. They are suitable for achieving ultra-short-term financial goals.
Floater Fund
These funds invest primarily in debt instruments with floating interest rates. They usually offer decent returns with low risk.
Corporate Bond Funds
These funds invest at least 80% of the corpus in high-rated corporate bonds. They offer stable returns with relatively low risk.
Gilt Funds
These funds invest at least 80% of the corpus in government securities with varying maturity periods. They are a safe investment option for risk-averse investors.
Dynamic Bond Funds
These funds have no fixed maturity period, and a fund manager actively manages the portfolio based on interest rate movements. They are suited for investors with an investment horizon of three to five years.
Credit Risk Funds
These funds primarily invest in lower-rated corporate bonds. While they offer slightly higher returns, they carry increased risk.Â
Bank and PSU Fund
As the name suggests, these funds invest at least 80% of the corpus in debt securities issued by banks and Public Sector Undertakings (PSUs). They are relatively safer investment instruments.
How To Invest In Debt Mutual Funds?
There are two ways to invest in debt mutual funds: lump sum and Systematic Investment Plan (SIP). Below are the steps to do so:
Set Your Financial Goals
Identify your investment objective, such as earning a steady income, preserving capital, or achieving short-term goals.
Choose the Right Fund
Choose a debt mutual fund scheme that aligns with your financial goals and risk tolerance. Consider factors such as the fund’s credit quality, maturity profile, and historical performance.
SIP or Lump Sum
Decide whether to invest through a lump sum or SIP. A lump sum allows you to make one-time investments, while an SIP enables you to invest a fixed amount at regular intervals.Â
Monitor Your Investment
Regularly review the performance of your debt mutual funds and make adjustments if needed.
Conclusion
Debt mutual funds offer a balanced approach to investing by combining capital safety with stable returns. They are an excellent choice for those looking to diversify their portfolio or achieve short-term financial goals. But before investing in a debt fund, analyse factors including your investment horizon, risk appetite, expense ratio, and tax implications.
To get started, open Demat account with HDFC SKY today. This account allows you to seamlessly invest in a gamut of instruments, including stocks, mutual funds, bonds, and ETFs.
