Debt Funds

Debt mutual funds invest in bonds and money-market instruments such as government bonds, corporate bonds, treasury bills, etc. that offer a fixed interest rate. The securities in these mutual funds are not tied to the stock market performance, making them less susceptible to market fluctuations and less risky as compared to an equity mutual fund. Debt funds are suitable for investors seeking stability, liquidity, and moderate returns over short to medium-term horizons.

Best Debt Mutual Funds

List of the top-performing debt mutual funds sorted by returns with their AUM and Expense Ratio.

What are Debt Funds?

Debt mutual funds are a type of mutual fund that pools money from investors to invest in fixed-income securities like corporate bonds, treasury bills, and government bonds. These securities are essentially loans given to companies or the government, where they promise to pay a fixed interest over time. Corporate bonds are issued by companies, while treasury bills and government bonds are issued by the government.

Debt funds invest in these securities and earn interest as returns. The interest paid by the companies or the government flows back to the fund and is distributed among investors. This distribution happens in proportion to the amount each investor has contributed. The returns are reflected in the fund’s Net Asset Value (NAV), which changes daily based on the performance of the securities. If the fund performs well, the NAV increases, and so does the value of your investment.

How do Debt Mutual Funds work?

The word debt means money is owed by one party to another. Before we understand how debt mutual funds work, let’s first look at why “debt” is needed. Imagine you run a company and want to set up a new plant for your business. The project requires ₹50 crores, but you only have ₹20 crores. To make up the difference, you’ll need to borrow ₹30 crores. When companies borrow money, they issue bonds. Bonds are a contract between the borrower and the lender.

Asset Management Companies (AMC) that manage debt mutual funds can purchase these bonds as investments. Now, where does the AMC get the money to lend you? It comes from investors like us who put their money into the debt mutual funds managed by the AMC. 

When we invest in the fund, our money is pooled together and lent out to companies like yours or invested in other fixed-income securities. The AMC will review your company’s financials and creditworthiness. The bonds act as a legal contract that specifies the principal amount borrowed, the interest rate, and the repayment period and other conditions.

What are the risks involved in a Debt Mutual Fund?

Like with any other debt, these funds carry certain risks. Here are the risks involved:

Interest Rate Risk: 

Interest rate risk is the risk that returns on fixed-income securities will be affected when there is a change in interest rates. In simple words, market interest rates do not remain constant, they change based on economic conditions. Bonds and market interest rates have an inverse relationship. When interest rates rise, new bonds are issued at higher coupon rates, which makes existing bonds less attractive, resulting in a decline in their market value or the NAV of a debt mutual fund. Alternatively, when interest rates fall existing bonds with higher coupon rates become more desirable, moving their market value up.

Credit Risk:

Credit risk is the risk of default by the borrower. Say a company issued a bond but eventually failed to generate enough revenue to repay the principal amount. When an entity issues a bond, credit rating agencies like CRISIL assess its creditworthiness. They’re rated from AAA to BBB based on how credible they are and the possibility of default. Since debt mutual funds invest in multiple bonds, if any borrower defaults, it will bringing down the value of the fund.

Liquidity Risk:

As the name suggests, liquidity risk arises when a debt mutual fund cannot easily sell its underlying securities. This happens when these funds invest in bonds, commercial papers, and treasury bills that are not frequently traded in the market. In this case, the fund manager will be forced to liquidate the bond holdings at a discounted price, potentially lowering the Net Asset Value of the fund and in turn impacting the returns of the investors.

Should I invest in Debt Mutual Funds?

To decide whether you should invest in a debt mutual fund or not, you must measure the good and the bad of each mutual fund category. For debt mutual funds, we know the following risks that are associated with it:

• Credit Risk
• Liquidity Risk
• Interest Rate Risk

Let’s also consider, the good side of debt mutual funds:

1. Debt funds tend to offer more stable returns than equity mutual funds. In the case of equity funds, the underlying assets are stocks that are traded in the market. In the case of debt mutual funds, your investments are at lower risk. This is because in case the company fails to perform, debt holders are paid back before equity holders. 

2. Debt mutual funds are popular for their high liquidity profile. This means that investors can withdraw funds whenever they wish and have the amount credited to their bank account within 2 to 3 days. However, in the case of other fixed-income securities like fixed deposits, there’s usually a lock-in period and heavy withdrawal charges are levied in case of early redemption.

Once the pros and cons of a debt mutual fund are weighed out. Debt funds could be a great fit if you identify yourself with the following characteristics of an investor:

Risk-averse: If you find investing in equity mutual funds too risky and need a stable option to place your money.

Short-term: If you do not consider yourself a long-term investor and are looking for short-term investment.

Diversification: When you need to diversify your portfolio or need a healthy mix of equity and debt in your portfolio.

Factors to consider before investing in Debt Mutual Funds

If you have decided to invest in debt mutual funds, here are some points you should consider before investing:

1. Consider your investment objective: 

Even within debt funds, there are multiple categories. For example, a bank & PSU debt fund invest in bonds issued by banks or PSUs. Similarly, a Government  bond fund would invest in Government bonds. Credit risk funds look to invest in bonds of companies with lower credit rating and higher credit risk looking to make higher return. Understand the kind of risks that apply to different types of debt funds before investing. 

2 Know your investment horizon:

How long are you planning to stay invested? Some investors use debt funds to park money temporarily. Some invest for stable returns in the long run. If you are clear about how long you wish to stay invested you can choose funds from long duration to ultra-short duration on that basis.

3. Your fund manager’s expertise:

Your fund manager’s track record plays a huge role in determining if the fund is an ideal investment or not. Whenever you decide on a fund it is important to analyse the fund manager’s expertise. A skilled fund manager would know how to evaluate credit risk and choose high-quality bonds. Similarly, they would know the importance of a balanced portfolio.

How do I Invest In Debt Mutual Funds?

You can invest in debt mutual funds easily on the INDmoney app. Follow the below steps to get started: 

Step 1: Log in to the INDmoney app. Create a Demat A/C if you don’t have one. It’s a one-time process and it only takes a few minutes.

Step 2: From the bottom menu bar, click on ‘Mutual Funds’.

Step 3: In the Explore section, search for ‘Debt Funds’. You can also skip the last step and directly search for ‘Debt Funds’ on the app.

Step 4: Choose a Debt Mutual Fund by looking at aspects like past returns, volatility, downside capture ratio, AUM, Expense ratios and underlying stocks and sectors.

Step 5: Choose the fund you wish to invest in. Click on ‘One-Time’ or ‘SIP’. Choose the amount, and frequency and confirm.

How to select the right Debt Mutual Funds?

Even the safest investments have some risk in them, which is why it is important to analyse key metrics before you decide which debt mutual fund is right for you:

1. Average Maturity: Look at the average maturity date of a fund. You can find this information easily on the funds' fact sheet. The average maturity is the average time it will take for all bonds in a debt mutual fund to mature. If an instrument matures early it allows the fund manager to reinvest that fund, maintaining liquidity of the fund. You can also compare the average maturity of a fund to that of its category average. 

For example, in the case of a long-duration debt fund, if the average maturity period is 2.5 years, the fund is exposed to both credit risk, and interest risk. In the case of liquid funds, the average maturity period is 91 days hence interest rate risk is extremely low.

2. Yield to Maturity (YTM): Look at the Yield to Maturity. This metric tells you what the total return on this instrument would be if it’s held till maturity and if the interests are reinvested into the security. Generally the higher the YTM the better it is. For example- If fund A has a YTM of 7% and fund B has a YTM of 6%, it indicates that fund A is a better option.

3. Funds Allocation: Apart from metrics, you also need to get an overview of the allocation of funds. So, if a liquid fund has allocation well diversified in corporate and government bonds, it's a good sign. However, it is heavily invested in corporate papers, especially for a shorter duration fund; it is taking on too much credit risk. You also need to look at the credit rating check that the fund has taken. 

4. Compare with category average: You must also measure how each fund measures compared to its category average or peers. Check how many securities the fund owns compared to its peers. What does the average maturity and Yield to Maturity look like?

How much tax do I have to pay on Debt Funds?

When you invest in debt funds, you’ll need to pay taxes on any gains you make. But the type and amount of tax depends on two things: how long you held the investment and when you invested. However, the tax treatment on your debt mutual funds is treated differently based on if you invest after or before April 1, 2023.

Let’s understand the treatment of Short Term Capital Gain (STCG):

If you hold your investment for less than 24 months, the profit is classified as Short-term Capital Gains (STCG).

STCG is taxed at your income tax slab rate, regardless of whether the investment was made before or after April 1, 2023. Let’s understand this with an example:

Imagine you invested ₹50,000 in a debt mutual fund and redeemed it within 6 months, making a gain of ₹3,500. Since the holding period is less than 24 months, this profit is considered short-term capital gain (STCG). Say you are in the 20% tax bracket, this will be your tax liability:

Tax payable = ₹3,500 × 20% = ₹700

In the case of long-term capital gains, If you hold your investment for more than 24 months, the profit is classified as Long-term Capital Gains (LTCG). The tax treatment in this case changes with two scenarios:

Scenario 1: Investments made after April 1, 2023, LTCG is taxed at your income tax slab rate.

Let’s understand this with an example, let’s say you invested ₹1,00,000 in a debt fund on May 1, 2023, and redeemed it on May 1, 2025, making a profit of ₹12,000. Since the holding period is more than 24 months, the profit will be taxed as LTCG. If you are in the 20% tax bracket:

Tax payable = ₹12,000 × 20% = ₹2,400

Scenario 2: Long-term Capital Gains (LTCG) for investments made before April 1, 2023, is taxed at a flat rate of 12.5%.

Let’s understand this with an example, If you invested ₹1,00,000 in a debt fund on March 1, 2022, and redeemed it on March 1, 2024, making a profit of ₹10,000, the holding period is more than 24 months, and the profit qualifies as LTCG. Since the investment was made before April 1, 2023, your tax liability would be:

Tax payable = ₹10,000 × 12.5% = ₹1,250

In summary, this is how the tax on debt mutual fund works: