What Are Debt Funds and how do they work?
Debt funds are mutual fund schemes that invest in fixed income instruments like government securities, corporate bonds, money market instruments, etc. They have the potential to offer capital appreciation over a period of time.
How do Debt Funds work?
Debt schemes aim to generate returns for investors by investing their money in avenues like bonds and other fixed-income securities basis asset allocation stated in the scheme information document. This means that these schemes buy the bonds and can earn cash flows in the form of interest on the invested amount depending on the nature of the instrument. This is similar to how a Fixed Deposit (FD) works. When you keep a deposit in your bank, you are technically lending money to the bank. In return, the bank offers interest income on the money lent.
However, there are many more nuances to debt fund investments. For example, a particular debt fund can buy only specific securities of specific maturity ranges - a gilt fund should invest minimum 80% in government securities while a liquid fund invests in securities of maturity upto 91 days. Debt funds also do not offer assured returns but have market linked returns which can fluctuate. Rising interest rates can have a positive impact on yields / interest income but a negative impact on bond prices. The reverse is true when interest rates fall.
Who should invest in a Debt Fund?
Debt funds are suitable for investors with a low to moderately risk appetite. Debt funds are less volatile in short term and therefore less risky than equity funds. Debt funds are recommended to conservative investors who don’t want to place a bet on equity funds. They can prove to be a good option for investors looking for returns with low volatility in short term. Debt funds may also help you diversify your investment portfolio and reduce overall portfolio risk in case you have a higher equity allocation in your portfolio.
Why invest in Debt Funds?
Debt funds can be a good option for conservative investors who would not like to invest in equity funds. Some major benefits of investing in debt funds are as follows:
- Potential Returns
Debt Funds have potential to offer capital appreciation over a period of time. While debt funds come with a lower degree of risk than equity funds, the returns are not guaranteed and are subject to market risks. Debt funds provide indexation on long term capital gains.
- High liquidity
Debt funds provide higher liquidity compared to fixed deposits. Fixed deposits (FD) come with a specified lock-in period. If you liquidate your FD prematurely, the lender may charge you a penalty. While open ended debt mutual funds schemes have no lock-in periods, some of the schemes carry an exit load which is a charge deducted at source for early withdrawals. Open ended Debt schemes do not have a maturity period and are thus liquid compared to FDs.
- Portfolio Stability
Investing in debt funds can also maintain the balance of your portfolio. Equity funds (while offering higher return potential) can be volatile in the short term. This is because the returns on equity funds are linked directly to the performance of the stock market. By investing in debt funds, you can adequately diversify your portfolio and bring down overall risk.
What are the different types of Debt Funds?
There are various types of schemes under debt mutual funds, which are classified on the basis of the type of instruments they invest in and the tenure of the instruments in the portfolio. Given below are some of the types of Debt Funds :
- Liquid Funds
Liquid Funds, as the name suggests, invest predominantly in highly liquid money market instruments and debt securities of very short tenure and hence provide high liquidity. They invest in very short-term instruments such as Treasury Bills (T-bills), Commercial Paper (CP), Certificates Of Deposit (CD) etc. that may have residual maturities of up to 91 days to generate optimal returns while maintaining safety and high liquidity.
- Short-Term funds
Short-term debt funds primarily invest in debt instruments with shorter maturity or duration. These primarily consist of debt and money market instruments and government securities. The investment horizon of these funds is longer than those of liquid funds, but shorter than those of medium-term funds.
- Floating Rate funds (FRF)
Floating Rate mutual funds are basically debt mutual funds which invest in fixed income securities and also floating interest rate securities like bonds, bank loans and other types of debt securities. When one invests in Floating Rate mutual funds, min 65% of their corpus is invested in securities with a floating rate instrument. The most notable advantage of a floating rate fund is that the fund is far less sensitive to interest rate changes, in comparison to instruments or funds which have a fixed coupon rate.
- Gilt Funds
The word ‘Gilt’ implies Government securities. A gilt fund invests in Government securities of various tenures issued by Central and State Governments. These funds have very less risk of default, since the issuer of the instruments is the Government.
- Dynamic Bond Funds
Dynamic Bond Funds invest in debt securities of different maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the interest rate view of the fund managers. Such funds give the Fund Manager the flexibility to invest in short- or long-term instruments based on his view on the interest rate movement. Dynamic Bond Funds follow an active portfolio duration management approach by keeping a close watch on various domestic and global macro-economic variables and interest rate outlook.
- Fixed Maturity Plans (FMPs)
Fixed Maturity Plans FMPs, as the name indicates, have a pre-determined maturity date (like a term deposit) and are close-ended debt mutual fund schemes. FMPs invest in debt instruments with a specific date of maturity, lesser than or equal to the maturity date of the scheme. After the date of maturity, the investment is redeemed at current NAV and the maturity proceeds are paid back to the investors.
- Capital Protection Oriented Funds
As the name suggests, Capital Protection Oriented Funds* (CaPro Funds) are mutual fund schemes that aim to protect the capital, i.e., the initial investment, providing an opportunity to make additional gains, as per the investment objective of the fund. These are close ended mutual fund schemes that aim to safeguard the principal amount while offering a potential equity-linked capital appreciation. However, it is important to note that there is no guarantee of returns or guaranteed capital protection.
Some of other types of Debt Funds are Overnight Funds, Ultra Short Term Funds, Money Market Funds, Banking and PSU Funds, etc.
How to invest in Debt Funds?
You can invest in a debt fund using two methods:
- Lump sum investments
- Systematic Investment Plans (SIP)
In case you have a considerable amount of money you wish to invest in one go, the lumpsum method is preferable. However, you must choose a fund type basis your investment horizon or your goal.
If you want to invest smaller portions of money at regular intervals, a Systematic Investment Plan (SIP) can be a suitable alternative. Investing through the SIP route enhances your investment discipline while reducing your risk through rupee cost averaging which helps to buy more units when prices are low and less units when prices are high.
Using Debt Funds for STP & SWP
A Systematic Transfer Plan (STP) allows you to transfer your investments from one mutual fund scheme to another, within the same fund house, at regular intervals. Such a transfer averages the cost of purchase, mitigating some market-related risks. For eg: an investor can park his funds in a debt fund and then transfer them via STP to an equity scheme of his choice in order to take advantage of the growth in equities.
Systematic withdrawal plan (SWP) is a payment option in a mutual fund that lets you redeem units of a pre-specified amount at specific intervals (monthly, quarterly, half-yearly or annually). This is suitable for the investors who desire to get periodic cash flows. For eg: an investor can use this facility on Debt Funds in order to generate a regular cash flow that can take care of his expenses.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
An Investor Education Initiative
Click Here to know more about the process to complete a one-time Know Your Customer (KYC) requirement to invest in Mutual Funds. Investors should only deal with registered Mutual Funds, details of which can be verified on the SEBI website (www.sebi.gov.in/intermediaries.html). For any queries, complaints & grievance redressal, investors may reach out to the AMCs and / or Investor Relations Officers. Additionally, investors may also lodge complaints on https://scores.gov.in if they are unsatisfied with the resolutions given by AMCs. SCORES portal facilitates you to lodge your complaint online with SEBI and subsequently view its status.
*The Scheme offered is “oriented towards protection of capital” and “not with guaranteed returns”. The orientation towards protection of the capital originates from the portfolio structure of the Scheme and not from any bank guarantee, insurance cover etc. The ability of the portfolio to meet capital protection on maturity to the investors can be impacted in certain circumstances including changes in government policies, interest rate movements in the market, credit defaults by bonds, expenses, reinvestment risk and risk associated with trading volumes, liquidity and settlement systems in equity and debt markets. Accordingly, investors may lose part or all of their investment (including original amount invested) in the Scheme. No guarantee or assurance, express or implied, is given that investors will receive the capital protected value at maturity or any other returns. Investors in the Scheme are not being offered any guaranteed / assured returns.”