A debt fund is a mutual fund scheme where the money is predominantly invested in fixed-income securities like government securities, debentures, corporate bonds, commercial papers, and other money-market instruments. The issuer of debt instruments pre-decides the interest rate you will receive as well as the maturity period. Hence, they are also known as ‘fixed-income’ securities. Individuals who are not willing to invest in a highly volatile equity market prefer to invest in debt funds as they are less volatile and provide a steady income.They are much more tax-efficient, compared to bank deposits. Debt mutual funds, including FMPs, carry indexation benefit and a lower rate of taxation if held for more than three years.
The fund’s managers of debt funds try to optimize returns by diversifying across different types of securities to earn decent returns. There are many types of debt mutual funds like Gilt fund, monthly income plans (MIPs), short term plans (STPs), liquid funds, and fixed maturity plans (FMPs), etc.
Following are some of the popular debt fund schemes offered by Mutual Fund Companies;
Liquid Funds: Liquid funds invest in debt instruments such as certificates of deposit, treasury bills, commercial papers, and so on with a maturity of not more than 91 days. As the investments are for a short period these investments are almost risk-free. Rarely have liquid funds seen negative returns. Liquid funds do not have a lock-in period. The request of the investors to withdraw the funds is normally processed within 24 hours on business days. Payments are made based on the NAV of the previous day. The notable benefit of liquid funds is that they do not have any entry or exit load. These funds are better alternatives to savings bank accounts as they provide similar liquidity with higher returns.
Fixed maturity plans (FMP): Fixed maturity plans (FMP) are closed-ended debt funds. Investment can be made only during the initial offer period. Investments in FMPs have a fixed maturity period like a fixed deposit for which your money will be locked-in.
Dynamic bond funds: Dynamic bond funds are a class of debt mutual funds that switch according to the fluctuating interest rate regime. These funds take interest rate calls and alter allocations between short-term and long-term bonds. This strategy helps in taking advantage of fluctuating interest rates.
Income Funds: Income Funds take a call on the interest rates and invest predominantly in debt securities with a maturity period of around 5-6 years. This makes them more stable than dynamic bond funds.
Monthly income plans: Monthly Income Plans (MIPs) are debt-oriented mutual funds that invest in a mix of debt and equity securities with a mandate of producing cash flows and preserving capital. Over 70% to 80% of the MIP corpus goes in debt funds and the remaining in equity funds. Because of this hybrid nature, they are also classified under hybrid funds. The payout is mostly monthly with an objective to provide the investor with a periodic income in the form of dividend and interest payments. Monthly Income Plans may be a good option for pensioners and senior citizens.
Credit opportunity funds: Investment in this type of funds is riskier as funds managers try to invest in the instrument which earn higher returns by taking a call on credit risks or by holding lower-rated bonds that come with higher interest rates. The investment in low-credit rated securities may have a higher probability of default.
Income from debt funds is taxable. The rate of taxation is based on the holding period, i.e., how long you stay invested in a debt fund. A capital gain from a shorter period of fewer than 3 years is known as a Short-term Capital Gain (STCG). A capital gain made over a period of 3 years or more is known as Long-term Capital Gains (LTCG). Investors can also add STCG from debt funds to his/her annual income. Here, the tax is as per the income slab.
Although investment in debt-funds is considered as safer investments they don’t offer guaranteed returns. The Net Asset Value (NAV) of a debt fund tends to fall with a rise in the overall interest rates in the economy. Hence, they are suitable for a falling interest rate regime. To know more about different types of mutual funds click ‘different types of Mutual fund schemes’