What are debt funds?

In India, mutual funds offer various types of schemes to investors under various categories such as equity funds, debt funds, and hybrid funds. Out of which, we are going to take a look at the debt funds in this article.  

Debt funds are fixed-income funds that are less volatile than equity funds. These funds invest in debt instruments like commercial papers, government securities, treasury bills, corporate bonds, and other money market instruments. The debt issuer pre-decides the interest as well as the maturity period. Investors with a lower risk capacity choose to invest in these types of funds. Ideally, the portfolio of every investor should consist of some proportion of debt for the stability of the portfolio. 

What should investors know before investing in these funds? 

Risk: Debt funds are riskier than any other fixed deposits as these funds consist of interest rate risk as well as credit risk. Fluctuations of interest rates cause changes in the value of the fund. The interest rate and value of debt funds (NAV) have an inverse relationship. Likewise, credit risk means the risk of default. 

Returns: Debt funds offer higher returns than fixed deposits but lower returns than equity. The net asset value (NAV) of the fund fluctuates with the change in interest rates. When the interest rate increases, the NAV of the fund falls whereas, when the interest rate falls, the NAV of the fund rises. Therefore, they are suitable in the falling interest rate phase. 

Expense ratio: The asset management companies charge fees for managing the fund and this fee is known as the expense ratio. The expense ratio is the percentage of the fund's total assets. It affects the returns of the fund.   

Investment horizon: Debt funds offer terms such as- 

Short-term investment horizon: Investors, who wish to invest for a shorter time period such as 3-month to 12-month, should opt for liquid funds that allow investing for a shorter time horizon. The typical tenure for the short term is 2-3 years. 

Medium-term investment horizon: Investors, who are ready to invest their money for 3-5 years, can invest in dynamic bond funds, which offer quite a high return than fixed deposits with the same lock-in period. 

Therefore, the longer the investment horizon, the greater is the returns. 

Taxation: Any capital gains arising on these funds vary depending upon the holding term of the investment. If any capital gains arising are less than three years, then it will be short-term capital gain, which will be taxed as per Income Tax slabs. If capital gains arising are more than three years, then it will be long-term capital gain, which will be taxed at the rate of 20 per cent.