Debt mutual funds are fund schemes that invest in instruments such as government securities, corporate bonds, commercial paper (CP), certificate of deposits (CD), T-bills and other such debt and money market instruments. They are called debt because the issuers of such instruments borrow money from lenders via these instruments. They are low-risk investments means and are comparatively more secure than equity funds which are subject to volatile market forces. These debt instruments come with different maturities; these debt schemes can generate income periodically or at maturity and help in building a diversified portfolio and so are one of the best ways to counter equity market volatility.
All debt mutual funds have an element of risk. Even though debt funds are fixed-income safe havens, they don’t offer any guaranteed returns. You may not find a debt fund with no risk at all. If the investors are extremely cautious; let us first consider the risks of investing in a debt fund.
Debt mutual funds are subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most debt and bond strategies are impacted by changes in interest rates. Debt, Bond and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk.
If you are investing in debt of an AAA rated company it is important that you need to be aware that there is no guarantee that a company would remain AAA forever. A company can get affected in market cycles and the ratings of its debt instruments may be downgraded. The future is not so easy to predict and so you cannot do anything about these unforeseen circumstances. A rule of thumb is to invest only in debt schemes having most investments in highest rated instruments. If you are not a sophisticated or well informed market savvy investor, stick with debt funds with shorter durations. Don’t invest randomly instead adopt the view to have low interest rate risk and limited credit risk.
There are various kinds of debt funds that can be added in an investor’s portfolio depending upon your investment goals and risk appetite. Risk averse investors should only consider schemes which have a large portion of their mutual fund portfolios in AAA rated debt. Short-term investors should look to put their money in liquid funds. These funds ensure a 5-8% return and can be withdrawn at any time, much like a bank savings account. For long-term investors, dynamic bond funds are considered one of the best debt funds to invest in via SIP mode.
GILT debt mutual fund schemes are alternative viable options and these schemes invest in Government of India securities and are 100% sovereign sponsored and are the safest instruments. According to SEBI, a Gilt fund is an open-ended debt scheme investing a minimum of 80% of its total assets in government securities across maturities.
As an investor you must always carefully consider your overall asset allocation in the context of your investment goals. Depending upon your investment horizon & the risk appetite, arrive at the ratio of debt and equity such as 40:60 or 50:50. Ideally, by maintaining a good balance between debt mutual funds and equity funds you can realize long term growth and reap the benefits of sound investing principles with lower portfolio volatility.
For taxation, all mutual funds with investments less than 65% in equity are considered debt funds. Short-term capital gains of fewer than 36 months are taxed conforming to the investor’s income tax slab. A tax rate of 20% is levied on long-term capital gains over 36 months after indexation. Indexation refers to the adjustment of the price of debt funds after factoring in the inflation between the years when that fund was purchased and the year when you sold the funds units. This adjustment allows for the inflation of purchase price, thereby bringing down the total amount of capital gains. This technique which is used by accountants subsequently, reduces your taxable income regularly.
The information, analysis and opinions expressed herein are for education purposes only and are not intended to provide specific advice or recommendations. This material is not an offer, solicitation or recommendation to purchase any financial products or services. Always remember that all investments carry some level of risk, including the potential loss of principal invested.