When it is the question of portfolio diversification, one must include debt funds to create a balanced portfolio. Investing in debt funds ensures low-risk income against market exposure involved with equity investment. Some common examples of debt funds are sovereign and corporate bonds, government securities, treasury bills, commercial papers, and similar debt instruments. These instruments create a steady source of income for the investors, often unaffected by market volatility.  The issuer pays pre-decided interest, payable at maturity. Hence, these are also called fixed-income investment.

What Is Debt Funds?

When companies or the government need money, they raise it from the market in forms of bonds. So, when you purchase bonds, you are actually lending money to these entities. Debt funds are types of mutual funds that invest in fixed-income generating debt instruments.

Debt funds are great investment products, especially for investors with a low-risk appetite, who want to generate a steady stream of income from their investment. If you have been saving in traditional saving instruments like FD or savings account, debt mutual funds are better options as it helps you get better returns.

How Does The Debt Funds Work?

Debt funds invest in a variety of fixed income securities like bonds and treasury bills, including gilt funds, and various monthly income plans, short term plans, and fixed maturity plans. A debt fund manager selects from the sea of debt plans available in the market that offer the highest return and carry high credit rating.

Credit rating refers to the rating given to various debt instruments by the credit rating agencies that signifies the issuer’s risk of default to pay back the debt. A higher rating means higher credibility. The fund manager invests in funds that carry the highest rating to ensure regular interest payment and maturity. Debt funds investing in higher rating debt instruments are less volatile and attractive to fund managers and investors alike.

Debt fund managers devise their investment strategies to generate a robust return for the investors, which prompts them to select long-term debt plans when interest rates are falling, and short term plans when it is high.

Advantages Of Investing In The Debt Funds

There are multiple advantages to investing in debt funds.

  • Debt funds are the best for investors with low risk-appetite who want a steady and assured return
  • Adds stability to your portfolio as well helps in diversification to ensure a balanced return in all market condition
  • No deduction of TDS or taxes. Taxes apply if an investor sells or withdraw fund units, depending on the length of the investment period
  • Debt funds generate a better return than traditional savings plans like Fixed Deposit
  • Offer cost advantages to investors as the charges are low compared to other mutual fund investments

Types Of Debt Funds

There are several types of debt mutual funds available for investment. Based on maturity and the instruments they invest in, debt funds are of the following classes.

Dynamic Bond Funds

It is dynamic because the portfolio composition keeps changing to adjust to the changing interest regime. Dynamic bond funds have different maturity since they invest in both long-term and short-term debt instruments depending on the interest rate.

Dynamic debt funds suit investors with moderate risk appetite with an investment horizon of 3-5 years.

Liquid Funds

liquid fund MFs invest in bonds with a maximum maturity of 91 days. These bonds offer a better return than traditional savings accounts over a short time.

Money Market Funds

These debt mutual funds invest in different money market instruments with a maximum maturity of one year, suitable for investors with a short-term investment plan.

Corporate Bond Funds

These funds invest up to 80 percent of the corpus into various corporate bonds with the highest rating to generate a higher return. These are good instruments for investors with low-risk tolerance.

Income Funds

As the name implies, income funds aim to generate income over a long term. Therefore, invest in long term bonds and debt instruments. Income funds have an average tenure of five to six years, making them more stable than dynamic bonds.

Short-term and Ultra Short-Term Funds

These funds have an average maturity of one to three years. These funds generate a stable return for investors seeking low-risk return for short-term.

Gilt Funds

Gilt funds invest in government-backed securities with a very high rating and low credit risk. Since a government will seldom default, these funds attract risk-averse investors who seek fixed-return on investment.

Banking and PSU Funds

Fund managers allot at least 80 percent of the corpus in different banking and PSU sector companies generating a steady, low-risk return on investment.

Credit Risk Funds

In credit risk funds, around 65 percent of the corpus gets allocated to less pristine credit rating funds, hence carry a higher risk than other debt mutual funds but also generate a better return.

Floater Funds

Fund managers allocate around 65 percent of the corpus to various floating rate instruments. In the scale measuring risks of debt funds, these are low-risk investments.

Fixed Maturity Plans

Fixed-maturity plans come with a lock-in period. You invest in these plans for a specific duration and receive a fixed return on maturity. These funds invest in various corporate and government bonds, which are low-risk.

The above list contains a broad classification of debt funds. But apart from these, there are several other combinations of debt mutual funds available for investment. We suggest you get clarity on the available options before investing in the best one.

Who Should Invest?

Debt funds appeal to investors across classes. These funds generate predictable returns which makes it easier to plan your future goals with debt funds.

Debt mutual funds have evolved and modernised to offer a wide range of short and medium-term investment opportunities.

Short-term debt funds

Liquid funds offer both liquidity and higher return for short-term investors. These funds have generated an average of 7 to 9 percent return.

Medium-term debt funds

Investors looking at an investment horizon of three to five years can choose dynamic debt funds to invest in. These funds are designed to ride interest rate volatility to generate a healthy return on investment.

Investors looking to create an alternative source of income can choose debt funds that are Monthly Income Plans (MIPs).

Things To Consider

Here are a few things to consider regarding investing in debt mutual funds.

Risk

Debt funds are low risk, but they are still riskier than fixed deposits in banks. These funds invest in various debt instruments in the market, hence, carries an inherent risk associated with market volatility and interest rate regime.

Return

The net asset value (NAV) of the investment will impact your return from these funds.

Fees

To invest in debt mutual funds, you have to pay an expense ratio. SEBI has fixed the upper limit for the same at 2.5 percent.

Investment Period

debt funds come with various maturity periods and even lock-in periods. Investors would need to select plans that suit their financial goal.

Tax

Capital gains from debt funds are subject to capital gain tax. Short-term capital gain is charged on investment for less than three years.

The Bottom Line

Debt funds help investors take advantage of low-risk debt instruments that generate a predictable return. Now that you have learned about debt funds plan your financial goals with them.