Debt Funding

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What are debt funds?

Debt mutual funds are a segment of mutual funds that primarily invest in fixed-income instruments such as corporate debt securities, money market instruments, and government and corporate bonds that offer capital appreciation.

These instruments offer fixed maturity dates and interest rates which ensures a higher degree of safety due to the lower credit risk because you are essentially lending money.According to the tenure of the securities held in the portfolio, the issuers of the securities, or their fund management strategies, debt funds can be divided into three categories:

  • Short-term funds, medium-term funds, and long-term funds.
  • Infrastructure debt fund, corporate bond fund, gilt fund, and treasury fund.
  • Fixed maturity plans, floating rate funds, and dynamic bond funds

Debt funds have the capacity to preserve capital and generate revenue. Most debt funds invest in a similar range of debt instruments and are suited to a conservative risk profile.

Who should invest in debt funds?

Debt funds are the preferred choice of conservative investors. They are also suitable for people with both short-term and medium-term investment horizons. Short-term ranges from three months to one year, while medium-term ranges from three years to five years.

  • Short-Term Debt Funds : For a short-term investor, debt funds like liquid funds may be an ideal investment, compared to keeping your money in a savings bank account.
  • Medium-Term Debt Funds : For a medium-term investor, debt funds like dynamic bond funds are ideal for riding out the interest rate volatility. When compared to 5-year bank FDs, debt bond funds offer higher returns. Investing in debt funds is ideal for risk-averse investors as they invest in securities that offer interest at a predefined rate and return the principal invested in full upon maturity.
  • Interest Rate Risk : The market price of the bond and interest rates carry an opposing relationship. Whenever interest rates in the market go up, the market prices of bonds come down.
  • Weighted Average Maturity Of The Portfolio : A portfolio of the debt mutual fund consists of various debt instruments maturing at different points in time. By looking at the average maturity of the portfolio one can identify whether the fund has invested in short, medium, or long-term debt papers. Higher the weighted average maturity, the longer the term papers of the portfolio and hence the higher the duration. High duration in a fund means higher volatility and vice-versa.

What are the risks associated with debt funds?

Every investment possesses some degree of inherent risk. Debt funds share some risks that are common across all mutual funds, such as no guarantee or assured returns and loss of principal amount due to market volatility, interest rate fluctuations, changes in government policy, and political developments. Apart from these common factors, there are some risks that specifically relate to debt funds. These risks are a direct result of the volatility inherent in the debt market and include:

  • Risk Of Total Loss : Debt and related securities can potentially result in a total loss of principal investments.
  • Price Risk : Market conditions can result in daily price fluctuations.
  • Liquidity Risk : Settlement periods can be unpredictably extended and the ability to sell can be restricted by the overall trading volume of specific stocks in the portfolio. This limits the ability of the fund to sell held securities which can result in potential losses and a fall in the value of the scheme.
  • Event Risk : Any unexpected or detrimental event impacting a company or industry in which the mutual fund is invested can result in price risk.

How to pick the right fund/scheme?

Investing in the right debt fund scheme differs from person to person. It is based on various factors – the most important being the ability to bear the risk and the willingness to take on the risk. Determining your own risk profile is essential in picking the right fund/scheme.

Other major factors include the financial goal and the time horizon for the investment. Here are some of the key factors to consider when selecting a debt fund right for your needs:

  • Investment Strategy/Objective : Every fund has a declared investment strategy and objective, that explains their approach to investment. Investors should understand the approach taken by these funds so they can decide if it matches their personal preferences.
  • Match Goals : Your investment goals can vary from tax savings to long-term capital appreciation. Knowing this can help you find funds that can support these goals.
  • Risk v/s Reward : Debt funds take higher risks for proportionately higher rewards. By analyzing the risks taken by the mutual fund, investors can discover if they match their own personal risk profile and preferences.
  • Liquidity Preference : Investors should know when they will need their investment corpus. Debt funds are designed for medium to long-term returns, with a minimum period of one year for any results to materialize. If your liquidity requirements are shorter than that, consider investing in debt funds instead.

Frequently Asked Questions

Short-term capital gains (if the units are sold before 36 months) in debt mutual funds are taxed as per the applicable tax rate of the investor. Therefore, if your tax rate is 30% then short-term capital gains tax on debt funds is 30% + 4% cess. Long-term capital gains (if the units are sold after 36 months) in the debt fund are taxed at 20% with indexation. Also, Dividends received by investors are added to their overall income and taxed at the income tax slab rate they fall under.

Debt funds are considered low-risk investments because you are essentially lending money. However, There are some risks to keep in mind. They are:

  • The Interest Rate Risk : Bond value is connected to the interest rate. So when interest rates rise. bond prices fall and vice versa.
  • Inflation Risk : Bonds provide fixed returns at regular intervals. But if the rate of inflation grows faster than the fixed amount of income, the investor's money is devaluing.
  • Credit Risk : There is always risk with any lending. that the borrower defaults. In debt funds, this is rare but possible.

Overnight funds and liquid funds are the safest because they are short-term which reduces the interest rate risk and credit risk that these funds can take. Overnight funds mature in 1-day. Liquid funds can only invest in debt and money market securities that mature in or up to 91 days.

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