Debt Funds: A Guideline On How To Diversify Your Investment Portfolio And Get Attractive Returns

Debt mutual funds focus an investor’s money in fixed-income avenues such as corporate bonds, government securities, and money market instruments

Capital gains from the debt funds held for more than three years are taxed at a subsidised rate and this helps in lowering the tax burden of an individual.

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With the start of the new fiscal year, it is time to plan your investments. One of the very lucrative investment avenues is mutual funds, which are preferred by individuals for their ease of management and diversification advantages. 

Before investing in a mutual fund, however, let’s try to look at what kind of mutual funds are available in the market so that you can make an informed decision. Broadly, there are three types of funds available for investors, namely, equity mutual funds, debt mutual funds, and hybrid mutual funds. 

Equity funds typically invest in the stocks of several companies, depending on their market capitalisation, sectors, etc. Debt mutual funds focus the investors’ money into a range of debt securities and money market instruments like debentures, treasury bills, government securities, and commercial papers, among others. Hybrid mutual funds, as the name suggests, infuse the investors’ money in a combination of both equity and debt markets.

In this article, let’s try to understand in detail what debt mutual funds are and how they add to an investor’s portfolio. 

What Are Debt Mutual Funds?

Debt mutual funds focus an investor’s money in fixed-income instruments such as corporate bonds, government securities, and money market instruments. These help investors in building a more stable and reliable income source. These funds are apt for investors with a relatively low-risk appetite and who plan to use the investment as a tool for capital preservation.

Types Of Debt Mutual Funds

There are different types of debt funds, such as ultra-short-term funds, overnight funds, long-term funds, floating rate funds, etc. Let’s take a look at some of the general variety of debt funds available for investors. 

Liquid Funds

These funds focus the investment on ultra-short-term avenues such as treasury bills and commercial papers, wherein the residual maturity is up to 91 days. They provide an individual the choice to invest in highly liquid instruments with low volatility. The redemption requests for these funds are processed within one working day.

Short-Term Debt Funds

These mutual funds invest majorly in debt instruments with a maturity period of up to 3 years, and thus, help the investor in opting for a relatively stable investment, but one with the potential to yield better returns than liquid funds. 

Income Funds

These debt funds focus the investment in a combination of corporate and government bonds, and thus, aim to provide the investor with a regular side income. Generally, these funds invest in instruments with medium to long-term maturity. 

Gilt Funds

These funds invest specifically in government securities, as ‘Gilt’ itself implies government securities. This exclusivity makes them one of the most reliable debt fund options and there is no risk of default typically as the instruments are issued by the government. However, their yield remains relatively lower than other debt funds. 

Fixed Maturity Plans (FMPs)

These are close-ended debt funds and have a fixed maturity period, as the name suggests. The tenure of FMPs generally ranges between 30 days to 60 months. Due to the close-ended nature of the fund, investors are not permitted to carry on any pre-mature redemptions. Therefore, for emergency liquidity needs, investors can opt to sell the FMP units via stock exchanges as they are compulsorily listed there. These funds offer investors more predictable returns and can also prove to be tax-efficient in the long run.

Dynamic Bond Funds

These funds invest capital in debt securities with different maturity periods. Due to their dynamic nature, they are more actively managed and allow the fund manager to invest in short or long-term instruments as per his decision.

Benefits of Debt Funds

Debt funds are a popular investment avenue. Let us understand the benefits these tools provide to investors.

Steady And Reliable Income Source

By offering regular interest payments from the securities, the debt funds help investors generate a stable income source. Additionally, the regular coupon payments offered by some debt funds help keep the money flow steady. Compared to equity funds, these funds are also more suitable for investors with a relatively lower risk appetite.

Liquidity And Higher Returns

Most debt funds, apart from FMPs, provide investors with high liquidity, in comparison to other investment avenues like fixed deposits (FDs). These funds allow investors to redeem their units at the existing value. In addition to liquidity, debt funds also yield potentially better returns than FDs, especially if you opt for a fund with a long duration.

Diversification

By investing in various securities, debt funds add great diversity to your portfolio and also reduce the risk that is linked with investing in any particular bond.

Tax Benefit

Debt funds also provide investors with great tax benefits. Capital gains from the debt funds held for more than three years are taxed at a subsidised rate and this helps in lowering the tax burden of an individual. They also provide indexation advantages. Indexation refers to managing the asset’s value based on the economy’s inflation level. This helps lower the tax burden for investors by adjusting the acquisition cost of the asset as per inflation.

Savings

Debt funds also promote a savings mentality among individuals. By putting aside funds to build an emergency corpus, it also helps build wealth for investors and shapes a healthy financial attitude. 

While debt funds provide several benefits for investors, be sure to find the one that suits your risk tolerance, investment goals, financial requirements, and liquidity needs. Always do your due diligence before investing money in mutual funds to capitalise on the investment opportunities.