What are debt mutual funds?

Understand how debt funds work and if you should invest in them

What are debt mutual funds?

Debt funds are a type of mutual funds that invest in fixed income-generating securities such as treasury bills (short-term debt instruments issued by the Government of India), government bonds, corporate bonds, other money market instruments, etc.

What are bonds, you might wonder? Let's start with the basics. Just like you go to a bank for a loan, governments and companies can borrow money from the financial market (think institutional investors and people like you and me). When they take the loan from the market, they issue a certificate of deposit called bonds.

And just like you need to pay an EMI to repay your bank loan, governments and companies pay an interest on the loan they have taken from the financial market. These instruments have a fixed maturity date and help you earn an interest till maturity.

Why do people invest in debt mutual funds?
We know that for wealth creation, equity funds are the most suitable investment. In fact, you can check the best equity mutual funds handpicked by our research team. However, they are not an ideal short-term investment option. By short-term, we mean one to three years.

So, where do you invest your money to meet your near-term goals? Enter debt mutual funds (debt funds in short).

Debt funds invest in fixed-income instruments, such as bonds. As explained earlier, investing in fixed-income securities is like giving out a loan and receiving a fixed interest on it. The interest you earn can be paid monthly, quarterly, semi-annually or annually. Because of this, debt funds are pretty stable compared to equity funds.

Another reason for people to invest in debt funds is diversification. Investing in them helps balance out the risk. Let's say you want to invest Rs 5 lakh. Putting all your money in equity funds can be risky. In order to reduce the risk, some portion of the money can be put in the relatively-safer debt funds.

The third reason is convenience. While you can directly invest in corporate bonds and government securities, it is a hassle. Also, there are several instruments that are not available to individual investors. Hence, it is much easier to invest through debt funds. They have the access to buy different types of fixed income securities. What's more, you can start investing in debt funds with just Rs 500 to Rs 1,000.

What else should you know before investing in debt funds?

  • Liquidity: You can exit your investment whenever you want and receive the money in two to three days' time. And unlike traditional avenues, debt funds don't have a lock-in period or a tedious withdrawal process.
  • Steady, yet moderate, returns: As debt funds invest in fixed-income securities, their returns are stable. However, since they are less risky, they yield a lower return than equity-oriented mutual funds.
  • Risks involved: Debt funds are not completely risk-free. Rise in the interest rate and credit default can be bad news for debt funds. Let's understand these one by one.
    Let's say the interest rates are going up or there is an expectation of the rates going up. When this happens, the newly-issued bonds start offering higher interest rates. As a result, the demand for existing bonds - those that might be a part of your debt fund - falls. And with it falls the price of the existing bonds and the value of the debt fund.
    The other kind of risk is credit risk. If any underlying bond issuer defaults and fails to honour the payments, it will affect the portfolio value of the debt fund. Hence, diversification is important in debt investments too.
  • Tax efficient: Unlike fixed deposits, where the accrued interest is taxed every year, mutual fund gains are taxable only when they are realised, i.e., at the time of selling the debt fund investment.
    For example, if you invest in an FD and earn Rs 5,000 interest every year, this amount is added to your taxable income for that year even if you do not realise the interest. However, in case of debt funds, if the value of your investment increases by Rs 15,000 by the end of the first year and you remain invested, you don't have to pay any tax. Only when you redeem your mutual investment are you required to pay tax.
  • Better returns compared to its peers: These funds have the ability to generate reasonably better returns than a savings bank account and even bank fixed deposits, especially after you calculate the tax. Hence, they are ideal for investors who are risk-averse and looking for short-term investments.

Want to start your debt fund journey? Invest in them with confidence by checking out our analysts' recommendations.

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