Debt Mutual Funds
Updated: Oct 27, 2022
Mutual funds that invest in debt and money market instruments fall under the category of debt mutual funds. Commercial papers, certificates of deposits, treasury bills, non-convertible debentures, government bonds, and G-Secs are a few examples of products used in the money market and debt markets.
Receiving income in the form of interest payments is the main goal of debt or money market instruments. Some debt funds may bring in capital gains for their investors. Bonds and fixed-income securities are where debt funds place their money to produce returns. Debt mutual funds are crucial for investors to include in their portfolios since they diversify the portfolio and shield it from stock market volatility.
Debt mutual funds can be used to park money for a day or to remain invested for over longer horizons. In general, it is advised to employ loan capital for projects with a lifespan of fewer than five years. The kind of debt fund an investor chooses will depend on their financial objectives, level of risk tolerance, and length of investment. Debt mutual funds provide high liquidity, low to moderate risk, and the ability for investors to protect themselves against market volatility. When compared to bank deposits, investing in debt mutual funds has the potential to yield better returns.
Category of Debt Mutual Funds: -
1. Liquid Fund
The liquid fund makes investments in debt obligations, where the borrower agrees to pay back the borrowed funds (principal) within 91 days of the borrowing's maturity. A corporate organisation will issue what is known as "commercial paper," or CPs, when it needs to borrow money on such a short-term basis. The government also makes short-term loans to cover its immediate financial needs. But when the government borrows money, it issues a treasury bill rather than a CP. People invest their excess funds in liquid funds with the intention to use it "sometime soon" as in the next year or, at best, the next year and a half. The goal of this investment is to safeguard the money and use it entirely for the intended purposes.
2. Overnight Fund
Debt funds that invest in securities with a one-day residual maturity are known as overnight funds. These aren't made to maximise profits. In contrast, they are similar to savings accounts in that the investment is secure and is easily withdrawable. So, as a group, overnight funds typically have low returns. In exchange for safety and liquidity, overnight fund investors must give up some of their return expectations. Because of this, investing in an overnight fund should be compatible with the investor's financial objectives and strategy rather than just a response to recent credit default incidents.
3. Ultra-Short Duration Fund
Ultra-Short Duration Funds are debt funds that can invest in short maturity bills and CPs and lend to businesses for a duration of three to six months. These funds are among the lowest risk categories of Schemes to invest in, although being somewhat higher risk than liquid funds because of their short lending period. If you want to park money for a year or two and are willing to take a little risk, this fund is a suitable choice. Park your money in this ultra-short duration fund if you're okay with the possibility that it could lose a few percentage points in value.
4. Low Duration Fund
Low duration debt funds are those that invest in short-term debt instruments, with a portfolio duration of between six and twelve months. Low duration funds contain assets with a longer term and/or lower credit quality than overnight or liquid funds; as a result, they have a considerably larger interest rate risk and credit risk. This works best in circumstances when you wish to temporarily park your money and use it for a certain purpose down the road.
5. Short-Term Fund
Short-term funds make loans to businesses for one to three years. These funds typically only invest in reputable businesses with a track record of making on-time loan repayments and enough operating cash flow to support the borrowing. While limiting risk, these vehicles typically offer higher returns than bank fixed deposits.
6. Medium Duration Fund
Debt funds with a medium tenure lend to reputable businesses for three to four years. Due to the longer loan term, the returns on these funds are influenced by variations in interest rates that borrowing corporations experience over time as a result of ups and downs in the economy. The returns from these funds may be unpredictable as a result.
Risk of Debt Mutual Funds: -
Cash Flow risk: The borrower may forego a few EMI payments and make erratic repayments. Unexpected financial flow will be negatively impacted by irregular repayments, which could trigger a series of unfavourable occurrences.
Default risk: If the borrower finds themselves in a really bad financial condition, they may opt not to return the loan. This is referred to as "default" or "default risk."
Interest rate risk: The loan is given out at a specific interest rate. The economy could, however, turn around and interest rates could decline in the future. This implies that the bank will be compelled to lower rates, which will negatively impact planned cash flow.
Credit rating risk: The bank evaluates the borrower’s credit rating at the time of giving out the loan. The borrower's credit standing may be outstanding at this stage. However, for any number of reasons, the borrower's credit rating could abruptly deteriorate, raising the danger of default.
Asset risk: The bank has the right to sell the property it has pledged as security in the event that the borrower defaults. What if the asset itself depreciates? The lender or the bank is dealing with a double whammy in this circumstance. Both the principle and the asset are lost by the bank.
Taxation on Debt Mutual Funds: -
Mutual funds that have a portfolio exposure to debt of more than 65% are referred to as debt funds. As shown in the table above, if you redeem your debt fund units during the first three years of holding them, you will receive short-term capital gains. These gains are included in your taxable income and taxed at the rate specified by your tax bracket.
When you sell units of a debt fund after three years of owning them, you realise long-term capital gains. After indexation, these gains are subject to a flat tax of 20%. Additionally, you must pay any applicable cess and surcharge on tax.