Why Should You Invest in Debt Mutual Funds for the Next 1-2 Years?

New Delhi (India), April 22: Finding the right investment option for your hard-earned money can be confusing. You want a safe investment that provides decent returns and has the flexibility to handle changing financial needs. For many Indian investors, debt mutual funds check all these boxes.

Debt fund is a type of mutual fund which invests your money in fixed-income instruments like government securities, corporate bonds, money market instruments, etc. This makes them less risky compared to equity funds. At the same time, they offer better returns than traditional fixed deposits (FDs), especially when interest rates are falling.

Read on to understand how debt funds work, who should invest in them, things to consider before investing, and taxation of debt funds.

How do Debt Funds Work?

Debt funds invest in fixed-income instruments like bonds, treasury bills, commercial paper, and other money market securities issued by governments, PSUs, banks, NBFCs, and corporates. As these instruments pay regular interest and return the principal amount on maturity, debt funds can provide stable income to investors.

How do Debt Funds in India Generate Returns?

Debt funds generate returns in two ways:

1. Coupon or Accrual Income: The fund earns interest income from bonds, government securities, money market instruments, etc., held in its portfolio. The rate of interest depends on factors like credit rating and tenure of the instruments.

2. Capital Gains/Losses: When interest rates in the economy rise, bond prices fall, leading to capital loss for debt funds. Similarly, falling interest rates lead to capital gains. The extent of gains/losses depends on the average maturity or duration of instruments held in the fund’s portfolio. The longer the maturity, the higher the interest rate sensitivity.

Based on the source of returns, debt funds can be broadly classified into two categories:

1. Short Duration Funds: They invest predominantly in the money market and short-term debt instruments. As a result, returns are mainly in the form of accrual/coupon income. Capital gains/losses are minimal. These funds offer stable returns with low to moderate volatility.

2. Long-Duration Funds: Most portfolios are allocated to long-term government and corporate bonds. A significant part of the returns is generated from capital gains when interest rates decline. However, these funds carry higher interest rate risk and can face large losses when rates increase sharply.

Strategies Employed by Fund Managers

Professional fund managers employ the following levers to optimize returns from debt funds within the permissible risk limits:

1. Varying Average Portfolio Maturity: Investment funds try to make money by buying and selling assets like stocks and bonds. When interest rates decrease, they try to make more money by buying longer-term assets. However, when interest rates increase, they try to avoid losing money by buying shorter-term assets.

2. Managing Credit Exposure: Investment funds can earn more money by investing in corporate bonds with a higher default risk. However, this also increases the chances of losing money. To avoid this, investment managers carefully choose which bonds to invest in, ensuring they are responsible for the money they manage.

Who Should Consider Investing in Debt Funds?

1. Retirees and Conservative Investors

Steady income generation with minimum volatility makes debt funds ideal for retirees as an alternative to bank FDs. First-time investors can also start here before exploring equity funds.

2. Aggressive Investors Combining Debt Funds with STPs

Using systematic transfer plans (STPs), equity investors can invest first in a debt fund and then transfer small amounts regularly into equity funds. This strategy helps in rupee cost averaging.

3. Investors with Temporary Surplus Funds

Households and businesses usually let surplus funds lie idle in savings accounts. Debt funds can put this money to work and generate better returns with low to moderate risk.

4. Investors Wanting Duration-based Investments

Investors can choose debt fund categories based on specific time horizons like liquid, ultra-short duration, short duration, medium duration, long duration, etc.

Aspects to Consider Before Investing in Debt Funds

While debt funds carry lower risk than equities, they are not completely risk-free. The following factors should be evaluated:

1. Interest Rate Risk Analysis

Using metrics like average maturity, portfolio yield, and modified duration, analyze how sensitive a fund is likely to be to interest rate changes.

2. Credit Profile Evaluation

Check the credit rating breakdown of the fund’s portfolio. Analyse issuer-wise exposures and sectoral concentrations to gauge credit risk levels.

3. Portfolio Holdings and Turnover

Evaluate portfolio composition, turnover ratio, fund manager’s investing strategy and experience to assess potential performance.

4. Risk-Return Tradeoff

Assess your risk appetite, return expectation and investment horizon to choose the debt fund category that best suits your needs.

Taxation of Debt Funds in India

Debt funds provide two taxable components:

1. Dividend Income: Taxable at applicable slab rates

2. Capital Gains:

● Short-term (≤ 3 years): Taxed at applicable slab rate

● Long-term (> 3 years): Taxed at 20% with indexation benefit

Indexation adjusts the purchase cost for inflation, thereby reducing capital gains tax liability. Hence, investing in the long term helps debt fund investors save taxes.

Conclusion

Debt funds offer income stability, lower volatility, and tax efficiency – making them suitable for conservative investors. They provide diversity beyond traditional fixed-income options like bank FDs. Investors can choose suitable debt funds by evaluating parameters like interest rate risk, credit risk, fund manager’s expertise, and taxes on income. A prudently crafted debt allocation can enhance stability and boost long-term returns on an investor’s portfolio.