A Beginner’s Guide to Debt Mutual Funds
Debt investment- this topic has been into a lot of contest since people started investing in the financial world, especially when people compare it with other investment options like equities or real estate. Although equity investments are known for their higher returns, however, investing in debt investments have their own benefits.
In general, if you have some idle funds and looking to invest in the financial market, you have two broad options. The first is to purchase something for a specific value and hope to dispose of at higher returns in the future. Such investment options include Stocks, Mutual Funds, Real Estates, Commodities, and Derivatives.
The other choice could be to lend your savings to some other person (or organization) and keep earning interests until you get your corpus back. This includes Bank Savings Account, Bank Fixed Deposit Account, Corporate Bonds, Government Bonds, and Debt Mutual Funds.
In this post, we will discuss what exactly are Debt Investments (focusing on debt mutual funds), types of debt funds, their benefits and more. However, before getting into that, let us first understand the basics of lending.
Basics of Lending:
The process of lending involves two parties. The borrower borrows the money from the lender as the former is in need of that. The former pays a specific regular payment known as “interest” to the latter for using the funds.
The loan is closed when the borrower repays the entire amount due to the lender. Here, ‘loan’ is also referred to as ‘credit’, ‘debt’ or ‘bond.’
Such instruments are called ‘fixed income securities’ because everything here is predetermined like the interest rate, maturity period, debtor and creditor.
How do Debt Mutual Funds work?
If you invest in a Debt Mutual Fund, you are simply giving loans to the issuing entity. Through Debt Fund investing, you can earn income in the form of interest and capital appreciation. You earn a pre-decided interest on Debt securities for a particular duration after the end of which such debt instrument will mature. Debt securities are also known as ‘fixed-income’ instruments as you are aware of what you will be getting.
In the case of Debt funds, the Fund Managers make investments across diversified securities. This gives ample scope for the Debt Funds for earning decent returns. Although no one can guarantee the returns for the same, however, debt fund yields return to fall in a predictable range. This makes the conservative investors interested in Debt Mutual Fund Investing.
The underlying assets of a Debt Fund usually consist of financial securities having a higher credit rating. The Debt Funds investing in higher-rated financial products will tend to be less volatile in comparison to low-rated securities.
An important thing to note here is that the duration (maturity) of the underlying depends on the Fund Manager’s investment strategy and the rate of interest prevailing in the economy. If the interest rate in the market falls, the Fund Manager may shift the underlying investments from short-term securities to the long-term ones and vice versa. The key differentiating factor among the varieties of Debt Funds is nothing but the maturity period of the underlying investments.
Types of Debt Funds
– Dynamic Bond Funds: In these funds, the Fund Managers keep altering the portfolio composition in accordance with the changing rate of interest in the economy. This fund’s average maturity period keeps fluctuating as the underlying portfolio is churned according to the rise and fall in the interest rates in the economy.
– Income Funds: These funds are similar to Dynamic Bond Funds but on most of the occasions, the underlying portfolio of Income Funds consists of securities having long-term maturity period. This gives more stability to the Income Funds as compared to Dynamic Bond Funds.
– Short-Term & Ultra Short-Term Debt Funds: These funds invest in the instruments having shorter maturity periods. Owing to their short-term nature, they are likely to be less affected by movements of interest rates.
– Liquid Funds: These funds invest in the fixed income securities which come with a maturity period of not exceeding 91 days. These funds seem to be a better option than keeping one’s liquidity in a savings bank account. This is because the former provides similar liquidity but at higher returns.
– Gilt Funds: These funds invest in only government instruments. The Government instruments are having high credit rating thereby come with low credit risk. Therefore, Gilt Funds are ideal investment products for the risk-averse investors who also prefer investing in the debt instruments.
– Credit Opportunities Funds: These funds aim in earning higher returns by taking a call on credit risks. These funds aim in holding lower-rated bonds that come with higher interest rates. The Credit Opportunities Funds can be riskier than any Debt Mutual Funds.
– Fixed Maturity Plans: These are closed-end Mutual Funds, which come with a lock-in period and invest in the debt securities. You can invest in Investments FMPs during the time of the initial offer period. An FMP is very similar to a fixed deposit, which yields excellent tax-efficient returns but it does not provide any guarantee for the same.
Who should invest in Debt Mutual Funds?
If you are a conservative investor, Debt Funds are an ideal investment option for you. You can even invest for a short-term period ranging from 3 months to 1 year. Debt Fund investing can also be of a medium-term which can range from 3 years to 5 years.
If you want to invest for a short-term where liquidity is your concern, then investing in the Liquid Funds could be more profitable than parking your money in a Savings Bank Account. Investing in the former would give you almost double the returns that you Bank Savings Account can yield for you.
For medium-term investing, you can go for Dynamic Bond Funds. Investing in such type of Debt Fund will fetch you more returns than a Bank FD of 5 years. For earning a regular income, you can look to opt for Monthly Income Plans (MIP).
What are the benefits of investing in Debt Funds?
– A perfect starter: During the early stage of your career, your income might be low and so be your savings. You might be unsure of where to invest your meager savings. Investing in debt fund would be a good starter to your investment journey. Gradually, you would learn more about investing, risk-reward relationship, financial planning and can diversify your portfolio with time.
– Adding stability to your investment portfolio: Debt Mutual Funds usually invest in the debt instruments. Therefore, they are comparatively more stable financial product than the equity investments. Debt Funds can provide some stability to your equity portfolio by diversifying the risk associated with your current investment portfolio.
– Long term growth: Through a Debt Fund investment, you would earn a return of around 8% without taking any significant risk. Further, if you hold your investment for more than three years, your investment would attract the benefit of indexation. Here, indexation allows you to inflate the purchase price using cost Inflation Index. In indexation, the purchase price is increased (adjusted for inflation) and deducted from the sale price to calculate long term capital gain. And obviously, this will reduce your taxable capital gains. In short, if you redeem your investments (partly or wholly) after three years, your returns in the form of capital gain would be more tax efficient as compared to keeping your money in a Fixed Deposit Account.
– Helpful in meeting emergency expenses: You should always have a fund for supporting yourself in unforeseen circumstances. Creating an emergency fund can help you a lot in tough situations. Here, investing in debt funds offer a great alternative to keeping your emergency money in the savings account as it offers similar liquidity, very low risk, and comparatively higher turns.
– Providing you liquidity: Debt Funds give you easy liquidity. You can keep investing your salaries in a Debt Mutual Fund and withdraw your money from such fund anytime. You can park your money in a Debt Funds and liquidate the same if you want to meet any of your needs.
Things to consider before you invest in a Debt Funds.
– Debt Funds are not entirely risk-free: Debt Funds are comparatively riskier than the Fixed Deposits as they are associated with both credit risk and interest rate risk. The Fund Manager might choose low-credit rated instruments for the underlying portfolio which gives rise to credit risk. Further, interest rate risk can be witnessed where the prices of the bonds may go down due to a rise in the interest rates.
– Cost: Debt Funds do charge you for managing your investment. Such fee is called an expense ratio. As per SEBI, the cap with respect to the expense ratio is 2.25%. Although the upper limit of expense ratio might look a little adverse, but over the long-term investment horizon, this would definitely help you in generating even higher money which you have paid in the expense ratio.
– There is no guarantee for returns: The underlying portfolio of a Debt Fund consists of fixed-income securities, but they don’t guarantee you any returns. The Net Asset Value (NAV) of your Debt Fund will fall if the interest rates in the economy shoot up as a whole. So, you would find Debt Mutual Funds attractive to be invested during the condition of falling interest rates in the market.
– Higher the holding period, better are the returns: You can consider investing in Debt Funds for any investment horizon as per your needs. However, this is to be noted that, the longer the investment horizon, the higher is the probability of gaining attractive returns.
– Achieving your long-term goals: Through Debt Fund investing, you can fulfill a plethora of your financial goals. You can make use of Debt Mutual Funds as a passive source of earning for supplementing your monthly salary. Furthermore, if you are a budding investor, you may invest some savings of yours in Debt Funds for meeting liquidity requirements. On the other hand, when you retire after around three decades, you may consider investing the lion’s share of your retirement benefits in some Debt Mutual Fund for receiving a regular pension.
– Don’t forget taxation on capital gains: When you redeem your units of a Debt Fund, you would earn income which is called capital gain. The capital gain is taxable. The rate of taxation of capital gains is dependent on the holding period of your units in such a fund.
The capital gain which is earned by you over an investment horizon of lower than three years is referred to as a Short-term Capital Gain (STCG). On the other hand, the capital gain of yours made by you on redeeming your units after holding them for 3 years or more is termed as Long-term Capital Gains (LTCG).
STCG earned by you is added to your net income which is thus going to be taxed as per your income slab. The LTCG earned by you will be taxed @ 20% after considering the effect of indexation.
Debt Mutual Funds are a wonderful investment option if you are a novice in financial market investing with low-risk tolerance.
As you gradually grow in your career, your earning increases and so does your risk appetite. Your investment keeps increasing and the proportion of Debt Fund in your investment portfolio keeps getting lower. However, when you retire, you would look for a stable source of income and again your financial assets will seem to be debt-heavy. So, your investment journey starts with Debt Fund and ends with the same. Therefore, you can’t really ignore the importance of the same in your professional career.
So, are you a fresher in the financial world and want to invest in low-risk investment options? Have you started investing for your future? If not, then what are you waiting for? Start your investment journey today with investing in the Debt Mutual Funds. Happy investing!
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