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Are you planning to invest your hard-earned money into a reliable source to generate stable and low-risk income? While fixed deposits might one way to get to these goals, Debt Mutual Funds or Debt Funds are a viable alternative. These schemes primarily invest in fixed-return instruments that usually feature low levels of returns volatility which is why they are often favoured by conservative investors.
Read on to find out more about how Debt Funds work, their various types, key features of these schemes and how they work.
What are Debt Funds?
Debt funds are mutual funds that invest a significant part of your money into securitised debt like bonds and money market instruments. These funds are also termed as fixed-income funds because securitized debt typically features a fixed rate of return. Investing in a debt instrument is like lending money to all the entities issuing the instrument. The issuers of debt instruments decide the interest rate and the maturity period well in advance. Hence, debt funds are also known as 'fixed-income' securities.
Types of Debt Funds as per SEBI Guidelines
Now that you know what are debt funds and debt funds meaning, you must know the types:
As per the rules of SEBI, the debt mutual funds are categorised based on the weighted average time taken to generate the cash flow till maturity. Keep scrolling through to learn the different types of debt funds:
- Overnight Funds
As per the guidelines of SEBI, overnight funds are all those that invest in assets that mature in just one day. These funds are short-duration funds. This type of mutual fund invests in money market instruments and repurchase agreements, commonly known as REPO.
- Liquid Funds
As per SEBI rules, liquid funds are considered the most suitable funds for short-term investment. This instrument has a maturity period of up to 91 days. Liquid funds are considered an ideal option as the shorter term implies that they are less prone to economic downturns. The instruments of liquid short-term debt funds include commercial papers, T-bills (Treasury Bills) and government securities.
- Ultra-Short Duration Funds
These are open-ended mutual funds that invest with a maturity period of 3 to 6 months. They include certificates of deposits, bonds and T-Bills.
- Low Duration Funds
As per SEBI guidelines, low-duration funds are open-ended debt mutual funds which invest in securities with an average maturity of 6-12 months.
- Short-Term Debt Funds
These debt funds usually invest in instruments with average residual maturity ranging between 1-3 years. The short-term debt funds invest in short-term corporate bonds, along with other government and money market instruments.
- Medium Duration Funds
These mutual funds make debt investments that have an average maturity of 3-4 years. The medium-duration funds invest in a mix of corporate debt instruments and bonds, government and money market securities.
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- Medium to Long Duration Funds
Unlike the other funds, medium to long-duration funds are ideal options for all those who are looking for a long-term investment with more risk appetite. As per SEBI guidelines, their investments have a maturity period of 4 to 7 years. It includes corporate debt and government securities.
- Long Duration Funds
These debt funds have the longest Macaulay duration of seven years or longer, which makes these mutual funds the most prone to duration risk. To mitigate this risk, investors need to stay invested in these schemes for a longer duration.
Benefits of Investing in Debt Funds
Debt funds offer numerous advantages to investors. Some of them are listed below:
- Opportunity to Multiply Wealth
Investing in debt funds gives you the advantage of adding to your investments through interest earnings as well as capital gains. In addition, it allows the investor to access the money market in which they cannot invest directly.
- Lower Portfolio Risk
Debt Funds can help diversify your investment portfolio which can help reduce the risk and reduce overall risk an investment portfolio. This occurs due to the relatively low correlation between debt and equity markets. Due to the comparatively lower volatility of debt markets compared to equity markets, the Net Asset Value (NAV) of a debt fund typically does not go through major ups and downs.
- Investment Range Options
Debt funds have a spectrum of maturity and credit risk. Schemes like ultra-short duration and short duration funds help in generating regular and stable income. At the same time, longer-duration funds have the opportunity to generate higher interest income in the short-term and capital gains in the longer term.
- Liquidity
Debt funds are very liquid funds and can be redeemed easily within a short period of placing the redemption request. Also, there is no lock-in period, and there are no penalties involved in withdrawing the fund invested.
- Low-Cost Investment
As per SEBI, the total expense ratio (TER) of a debt fund cannot exceed 2%. Liquid funds and overnight funds come with very low expense ratios. This has the potential of increasing the overall gains that an investor can receive.
3 Common Risks of Debt Fund Investments
No investment is completely without risk and the same is true for Debt Funds. This is the case even though debt funds are less volatile as compared equity investments, especially in the short term. Below are the key risks you need to consider before making debt fund investments:
Interest Rate Risk
Since Debt Funds primarily invest in bonds and other fixed-return instruments, they offer a fixed rate of return in the form of coupon rate. So, changes in market rates like repo and reverse-repo can impact the returns offered by debt funds. This is the basis of interest rate risk in the case of Debt Funds.
As a rule of thumb, when market interest rates increase, bond prices decrease and when market interest rates decrease, bond prices increase. An increase in bond prices increases the return from debt funds, while decrease in bond prices leads to a decline in debt fund returns. The interest rate risk of a debt fund is measured using modified duration of the scheme. Higher modified duration means higher risk, while lower modified duration means lower risk to the investor.
Credit Risk
The key reason for credit risk in Debt Funds is linked to the quality of investments that the scheme makes. Lower quality bonds and money market instruments are considered to be of higher risk that higher quality debt instruments like Government securities (G-Secs) and Treasury Bills (T-Bills). However, higher quality debt instruments typically offer lower coupon-rates as compared to relatively lower quality debt investment. This can impact returns that the investor can receive. Credit risk in this case relates to the possibility that low-quality investments of a debt fund might default on its coupon payments and impact the overall returns of the scheme.
Credit Risk
The key reason for credit risk in Debt Funds is linked to the quality of investments that the scheme makes. Lower quality bonds and money market instruments are considered to be of higher risk that higher quality debt instruments like Government securities (G-Secs) and Treasury Bills (T-Bills). However, higher quality debt instruments typically offer lower coupon-rates as compared to relatively lower quality debt investment. This can impact returns that the investor can receive. Credit risk in this case relates to the possibility that low-quality investments of a debt fund might default on its coupon payments and impact the overall returns of the scheme.
Who Should Invest in Debt Funds?
If you wonder whether short-term debt funds are the right choice for you or not, then you should not worry. These funds have something for every investor whether they plan to make lump sum investments or via Systematic Investment Plan (SIP). Here is the list of investors who can park their funds in debt to earn low to moderate returns.
- Novice Investor who have limited market experience
- Equity investors who want to diversify their investments
- Experienced investors who want to diversify their portfolio
- Investors with low to moderate risk appetite
How to Invest in Debt Funds?
Investing in debt funds is a simple and hassle-free process, which involves some easy steps. Keep scrolling through to learn how to invest in debt funds:
- Register online on the investment portal like the AMC website or RTA website/app
- Submit all the required documents
- Enter investment details
- Complete the KYC process
- Choose the right plan and invest via either lump sum investments or SIP route
To choose the best debt fund to park your surplus money, it is extremely crucial to take into account various factors, like risk, returns, fees, the maturity period of the funds, and tax on mutual funds. Select the best fund for yourself on the basis of your risk appetite and investment horizon.
Frequently Asked Questions (FAQs)
1. Are debt funds risky?
You can find numerous debt fund options that have negligible or zero risk, like overnight funds and liquid funds. In contrast, some debt funds do carry a lot of risks. Therefore, it is a must to do thorough research about the options available before selecting one.
2. Which short-term debt fund should I invest in?
The selection of debt funds depends upon the investment horizon. If you are making a short-term investment for say to up to a month, then you must opt for overnight funds or liquid funds. Whereas, for an investment of up to 6 months, go for ultra-short-term debt funds. For 6 months to a 1-year investment period, opt for money market funds. In case you are planning to invest for 1 year, and 3 years, you can opt for Corporate Bond Funds or Short Duration Bond Funds.
3. Is it a good option to invest in debt funds?
If you want to preserve your capital and at the same time want to earn better post-tax returns than fixed-return investments like fixed deposits and recurring deposits, investing in debt funds is a wise decision. These funds help to fulfil your near-term goals.
4. Do debt funds have any lock-in period?
No, debt funds are not backed by any lock-in period, thus offering the advantage of the flexibility to the investor.
5. How can I choose which debt funds to invest in?
To choose a suitable investment plan using debt mutual funds, the first and foremost thing to decide is the investment horizon. Doing this will help you select the right Debt Fund category. After deciding on the horizon, you must pick a fund from the category. Go for a fund that lends your money to good companies to generate high profits.
Sources:
https://economictimes.indiatimes.com/definition/debt-funds
https://www.mutualfundssahihai.com/en/what-are-debt-funds
https://www.mutualfundssahihai.com/en/what-are-different-types-debt-funds
https://economictimes.indiatimes.com/understanding-risk-in-debt-mutual-funds/tomorrowmakersshow/69426898.cms
https://mf.nipponindiaim.com/knowledge-center/what-are-debt-funds/who-should-invest-in-debt-fund
https://www.5paisa.com/stock-market-guide/mutual-funds/what-is-debt-fund
https://economictimes.indiatimes.com/mf/analysis/best-short-duration-mutual-funds-to-invest-in-2022/articleshow/88680391.cms?from=mdr
ARN No: Nov22/Bg/10D
Disclaimer:
The investment risk in Investment portfolio is borne by the policyholder.
