Debt Mutual Funds are funds that invest in fixed income securities such as bonds, government securities, treasury bills and other money market securities.
To understand a debt mutual fund, it is important to understand what a fixed income security is. A fixed income instrument represents an investment where the investor lends money for a certain period of time (the maturity), against which the investor receives periodic interest payments and the return of capital at maturity.
A bank fixed deposit is an example of a fixed income security.
Since debt mutual funds invest in low-risk fixed income securities (and not equity), they offer a much lower risk-return compared to equity funds.
What determines the returns earned by a debt MF?
The returns earned by a debt mutual fund are determined by 2 main factors
Yield
The yield (interest rate/coupon) of the securities held are the key determinant of the return potential of the debt fund. There are 2 main factors that impact yields:
Maturity: debt with a higher maturity typically offer a higher yield, but this is accompanied with a higher interest-rate risk
Credit-risk: debt issued by lower-rated corporates offer a higher yield, but this is accompanied with a higher credit-risk
Change in Interest Rates
If market interest rates go down, existing bonds (offering a higher coupon) become more valuable, leading to CAPITAL GAINS.
If market interest rates go up, existing bonds (offering a lower coupon) lose some value, leading to CAPITAL LOSSES.
Debt funds are thus subject to interest-rate risk, that is determined by the maturity of their holdings.
Why Debt MFs are superior to Bank Deposits
Debt Mutual Funds offer investor’s a risk-reward that is fairly similar to bank fixed deposits. However, there are 2 primary factors that make Debt Mutual Funds a much superior investment options:
More tax-efficient
Unlike Bank Fixed-Deposits that are taxed every year on your entire capital, Debt MF’s are only taxed on redemption and only for the gains on the units that you have redeemed. Any gains on units that are not redeemed are not subject to tax, until such time as they are not redeemed.
This can 3 primary benefits:
- Can delay tax payments considerably
- Until you do not make any redemptions, the interest eared on debt Mutual Funds are compounding on a pre-tax basis (compared to on a post-tax basis in Bank Fixed Deposits)
- Can possibly lead to tax liability taking place at a time when your tax rate is lower (for example if you only start redemptions post retirement in a year when your income is lower)
More flexible
When you invest in Debt MFs, you are allocated a certain number of units (based on your investment amount and the NAV).
You are free to make small incremental investments / withdrawals (can be as low as Rs. 1000) and you are free to keep your money invested for as long as you require. There is no need to decide your investment period at the time of your investing.
Redemption’s from Debt MF’s take place on a T+1 basis. As long as you redeem before the cut-off time, the money will hit your bank account on the next working-day.
Debt MFs offer much higher post-tax yields with greater flexibility, than bank deposits that are both tax-inefficient and rigid.
The different types of Debt Mutual Funds
Debt Mutual Funds have many different sub-categories, based on the type of fixed-income securities that the funds invest’s in. The funds are categorized on the basis of 2 main factors: (1) Maturity of the securities (2) Credit Risk of the Issuer.
The following are the primary types of Debt Mutual Funds:
- Ultra Short-Duration & Low Duration : funds that invest in securities with a maturity of 1-365 days. These funds have very low interest-rate risk and are great alternatives to bank savings/current accounts.
- Short-Duration: funds that invest in securities with a maturity of 1-3 years. These funds have low interest-rate risk and are a good alternative of bank fixed deposits.
- Longer-Duration: broken up into medium (3-4 years), medium to long (4-7 years) and long-duration funds (7 years+). Due to a higher level of interest rate risk, these funds are typically not recommended for investors (these are more relevant for financially savvy investors seeking to play the interest rate cycle).
- Dynamic Duration funds: When interest rates are falling, it is better to hold longer-maturity paper, and when interest rates are rising short-maturity paper is preferable. Dynamic duration funds are funds where the fund manager can dynamically alter the maturity of the papers held, based on the fund managers views on likely interest rate movements.
- Corporate Bond: debt funds that invest in highly rated corporate bonds (min of 80% in highly rated corporate bonds)
- Gilt: debt funds that invest exclusively in government-securities (carrying virtually no credit risk). While gilt funds carry low credit risk, the higher duration of government securities does lead to these funds having a higher interest rate risk on their portfolio.
- Credit-Risk: relatively higher-risk debt funds, that invest a minimum of 65% of their assets in lower-rated corporate bonds. These funds are typically not recommended to investors (unless they are financially savvy and clearly understand the risk).
- What do maturity categorised debt funds invest in?: debt mutual funds that are categories based on the maturity of the holdings, typically have the flexibility to invest across government securities, bank certificate of deposits, treasury bills, bonds and other money market instruments.