What are debt funds?

For generations of Indians, fixed deposits (FDs) have been the go-to option for securely building their savings. While FDs are safe, they often fall short of providing inflation-beating returns. As a result, money left in a bank FD for years loses its value over time due to rising prices.

Enter debt funds, a low-risk alternative that offers better returns, often just outpacing inflation. These funds also provide greater liquidity, allowing early withdrawals without penalties in most cases. Additionally, they offer tax advantages compared to FDs, making them a compelling option for conservative investors.

Curious about how debt funds work? In this article, we'll give you a complete rundown to help you decide if these funds deserve a place in your investment portfolio.

Understanding debt funds

They are a category of mutual funds that primarily invest in fixed-income securities such as corporate bonds, government securities, treasury bills, and other money-market instruments. These funds aim to provide stable returns by earning interest income and, in some cases, through capital appreciation when the securities are sold at a profit.

The net asset value ( NAV ) of a debt fund fluctuates based on changes in interest rates, credit ratings of the securities and other market conditions. These factors collectively determine the returns for investors.

They receive regular interest payouts from their underlying debt instruments, known as coupon payments. These payments contribute to the fund's income and are reflected in its NAV.

The prevailing interest rate environment also plays a significant role in determining returns. For instance:

• Falling interest rates: When rates decrease, newly issued securities offer lower yields. This makes existing securities with higher interest rates more attractive, driving up their prices and the NAV of funds holding them.
  
• Rising interest rates: When rates rise, the value of existing securities declines, potentially lowering the fund's NAV.

Thus, these funds grow wealth in two primary ways:

• Coupon payments: Regular interest income from the securities in the portfolio.
  
• Capital appreciation: An increase in the market value of securities when interest rates fall or credit ratings improve.

Suggested read: A basic introduction to debt funds

Who should invest in debt funds?

These funds are particularly suitable for:

1. Short- and medium-term investors

If you're looking to park your money for a few months to a few years, these funds typically offer better returns than FDs without the restriction of a lock-in period.

2. Conservative investors

Those who prioritise capital preservation over high returns will find these funds appealing due to their relatively low risk.

3. Tax-conscious individuals

These funds offer a slight tax advantage over FDs. We'll explain why in subsequent sections.

Suggested read: Modi & 95 per cent Indians love FDs. But there's a better alternative

What are their risks?

While they are relatively safer than equity funds, they are not entirely risk-free. Investors should consider the following risks:

1. Credit risk

This refers to the possibility of the bond issuer defaulting on interest or principal payments. Funds investing in lower-rated bonds carry a higher credit risk.

2. Interest rate risk

Fluctuations in interest rates can impact the market value of bonds held by the fund, affecting its NAV. Funds with longer maturity periods are more susceptible to this risk.

To mitigate these risks, consider funds that invest in high-quality securities and have shorter maturity durations.

Suggested read: Understanding risk in mutual funds

What are the major types?

There is a vast spectrum of debt funds based on risk tolerance and time horizon. Let's walk through three of the major categories:

1. Liquid funds

These funds invest in securities with a maturity of not more than 91 days, making them a good alternative to savings accounts or FDs. They are suitable for short-term needs, such as parking money for a few days to a few months. These funds exhibit minimal fluctuation in NAV, providing a stable option for conservative investors.

2. Ultra short-duration funds

Most of these funds invest in securities with a Macaulay duration of three to six months. This makes them ideal for investors looking to park money for a few months to a year. While they carry slightly more risk than liquid funds due to their longer duration, they also offer better returns.

3. Short-duration funds

These funds invest primarily in debt securities with an average maturity of one year to 4.5 years. They are suitable for conservative investors with a medium-term horizon who are willing to accept slightly higher risk in exchange for better returns than FDs.

Suggested read: The range of debt funds

Benefits of debt funds

These funds offer several advantages that make them stand out from traditional savings options like FDs:

1. Liquidity

Most of these funds have no lock-in period, allowing investors to withdraw their money anytime. However, some funds may charge an exit load if redeemed within a specific timeframe.

2. Low risk

These funds are less risky than equity funds as their returns are not tied to stock market fluctuations. However, they do carry risks such as interest rate and credit risk, as discussed earlier.

3. Tax efficiency

These funds are more tax-efficient than FDs . This is because no taxes are levied on gains until you redeem your investment. Meanwhile, interest payments from an FD are taxed as part of your income.

How are they taxed?

Over time, the taxation for these funds has become a challenging aspect. Here's a breakdown of how they are taxed.

Suggested read: Mutual fund taxation: Here's how it works

Are debt funds right for you?

These funds can be an excellent choice for investors seeking an alternative to FDs with slightly higher returns and greater liquidity. They cater to a wide range of investors, from those seeking short-term parking options to those aiming for stable medium-term growth.

However, these funds are not recommended for long-term investing. Over longer periods, the likelihood of rising interest rates could erode returns. Additionally, equity investments are better suited for generating inflation-beating returns in the long run. History shows that equities have consistently provided positive real returns over extended time horizons.

By understanding the benefits and risks of these funds, you can make informed decisions about incorporating them into your portfolio. Ensure that your choice aligns with your financial goals and time horizon to maximise the benefits of these versatile investment options.

If you're a safety-first investor who needs to park their money, then debt funds can be a good choice. However, there are so many options to choose from in this segment, making it overwhelming to get a good start. If you need a financial guide for choosing debt funds or any other category, you can try out Value Research Fund Advisor. Our service offers expert fund recommendations that help you pick investments aligned with your financial goals.

Also read:
How debt mutual funds work
These debt funds may thrive, thanks to rate cuts

This article was originally published on December 20, 2024.