Investing in debt mutual funds may be a complex activity. It involves a thorough grasp of bond markets, interest rate cycles, macroeconomic emotions, and central bank monetary policies. In this blog-post, we’ll look at the key details that investors need to be aware of while investing in debt mutual funds.
Any debt fund investor just wants capital preservation and somewhat higher rates than bank savings. As an investor, the bare minimum you should anticipate from your investments is that you do not have to change your investment strategy in reaction to shifts in market dynamics. This is especially relevant for debt fund investors. Whether you invest in stocks or debt funds, your investment strategy should be robust enough to endure market fluctuations.
First of all, what are Debt Funds?
Debt funds make investments in fixed-income assets such as treasury bills, corporate bonds, commercial paper, government securities, and a variety of other instruments in the money market. All of these instruments have a set maturity date and interest rate that the purchaser will get when the instrument matures. Fixed income securities’ returns tend to be more stable than stock returns. As a result, debt funds are considered low-risk investment instruments and hence are ideal for investors who dislike taking risks. This is the reason why debt funds invest in securities that pay a set rate of interest to its investors and repay back the principal money invested in full at maturity.
How do these debt funds work:
Debt funds make investments in a variety of assets based on credit ratings. The credit rating of a security shows the likelihood of default in providing the returns promised by the debt instrument provider. A debt fund’s fund manager ensures that it engages in high-quality credit instruments. A higher credit rating suggests that the company is more inclined to pay interests on the debt security on a regular schedule and refund the principal amount when the instrument matures.
Debt funds that allocate funds to higher-rated instruments have lower volatility than those that invest in lower-rated instruments. In addition, maturity is influenced by the fund manager’s investment approach and the overall interest rate environment in the economy. Low interest rates motivate fund managers to put money in long-term securities. In contrast, higher interest rates encourage them to invest in assets with short maturities.
Target Audience and Types of debt funds:
Debt funds seek to maximise profits by investing in all debt products. This allows debt funds to make respectable returns. Debt fund investment returns are predictable, but not guaranteed. They provide more safe solutions for conservative investors. They are also suitable for those with short and medium-term investment goals. The short period is generally assumed to be from three months to a year, while the medium term is three to five years.
There are various types of debt mutual funds offered to fulfil the needs of a diverse group of investors. The maturity period of the instruments in which debt funds invest is the primary differentiating factor. We will not go into the various types of debt funds here, since you can readily find them through Google searches. Instead, the primary objective of this blog article is to offer you an idea of what we should bear in mind while making investments in debt funds.
Points to Ponder before investing:
The below are some key pointers that you must consider before investing in debt funds:
- Risk and Return – Debt funds are riskier than bank fixed deposits because of credit and interest rate risk. Credit risk occurs when the fund manager invests in debt instruments with a low credit rating, increasing the likelihood of default. Also, the price of bonds may fall as interest rates rise, posing an interest rate risk. Even though debt funds are oases of safety for fixed-income investors, they do not guarantee returns. When interest rates rise in the economy, the net asset value (NAV) of a debt fund falls. As a result, they tend to work well in a low-interest rate economy.
- Expense Ratio – An expense ratio is the fee imposed by debt fund managers to handle the money you that you have invested in that fund. The capital markets regulator Securities and Exchange Board of India (SEBI) has stipulated that the maximum expenditure ratio shall not exceed 2.25 percent of the total assets managed by the fund. Given that debt funds give lower returns than equity funds, a long-term investment horizon would help to recuperate the money lost owing to expense ratio.
- Investment Horizon and your Goals – If you are looking for a three-month to one-year investment horizon, liquid funds are an excellent choice. Short-term bond funds, on the other hand, generally have duration of two to three years. Dynamic bond funds are suitable for a medium horizon of 3-5 years. In broad terms, it’s sensible to make investments based on the time horizon of your financial objectives.
- Financial Objectives – You can use interest income from these debt funds as an extra source of income to supplement your wage. In addition, new investors may also put money into debt funds for liquidity. To get a fixed income like a pension, retirees might invest the vast majority of their savings for retirement in debt funds. (But this has to be done only after careful due diligence on the debt funds).
- Taxation – Dividends from all forms of mutual funds are taxed in the traditional manner. They are included to your overall income and taxed according to your tax slab. The duration of the hold determines the tax liability for capital gains derived from these debt funds. Short-term capital gains are those that occur after a holding period of less than three years. These profits are added to your overall income and taxed based on the investor’s tax slab rate. Long-term capital gains occur after a three-year holding period. These long term profits are taxed at 20%, with indexation advantages.
Conclusion:
Dealing in debt mutual funds isn’t as simple as putting your money in a bank fixed deposit. As previously discussed, there are several aspects to consider before investing in a debt mutual fund. As a debt mutual fund investor, you should be very clear about your investment horizon, risk tolerance, and investment objectives before investing in these products.
