A debt fund is a type of mutual fund scheme that primarily allocates its investments to fixed-income securities. These fixed-income instruments encompass a range of assets such as corporate and government bonds, money market instruments, treasury bills, and commercial papers, among others. Debt funds, often referred to as fixed-income or bond funds, are designed to offer investors a regular income stream, relatively stable returns, and high liquidity. These investment vehicles are particularly well-suited for individuals who prefer lower risk in their investment strategies. Skilled fund managers oversee debt funds and make portfolio decisions aligned with the specific objectives of each fund.

Debt Fund Meaning

Debt funds are mutual fund schemes that invest in fixed-income securities such as money market instruments, corporate debt securities etc. that may come with a fixed interest rate, reducing the overall investment risk. Additionally, these securities may have a defined maturity date, ensuring a regular, fixed income stream for investors. Debt instruments are largely insulated from stock market movements. This makes them a relatively low-risk investment option and suits investors looking for capital preservation and regular income generation. Nonetheless, it's crucial to be aware of potential risks associated with debt funds, such as interest rate fluctuations, credit risk, and reinvestment rate risk. Skilled fund managers strive to navigate these risks while pursuing the fund's objectives.

How does a debt mutual fund work?

Debt funds invest in fixed income securities based on their credit rating given by agencies. Credit rating indicates the risk of default in interest or principal repayment. Ratings are grades that refer to the creditworthiness of the issuer. A higher credit rating means the issuer company/entity is likely to repay the principal amount and pay interest on time to the investor. In this case, the mutual fund house is the investor.

Also Read - Fixed Income Mutual Funds: Things to Know before Investing

So, depending on the type of debt fund, debt fund managers invest in different debt instruments. Suppose a significant portion of a debt fund is invested in highly rated papers, say AAA, in that case, we can consider the debt fund a safer option than a debt fund that invests in AA rated or lower-rated debt securities.

Who Should Invest in Debt Mutual Funds?

Debt mutual funds are most appealing to investors seeking stability and consistent income rather than chasing high-risk growth. Specifically, they can be an excellent choice for conservative investors, especially those approaching or already in retirement, who prioritize capital preservation and income generation. This preference aligns well with debt funds' focus on fixed-income instruments, which are inherently less volatile than equities. Additionally, debt funds can act as a stabilizing component in a diversified portfolio, comprising both equities and fixed-income securities.

Younger investors embarking on their investment journey may also consider including debt funds in their core holdings to achieve diversification and stability. These funds can also serve individuals building an emergency fund or saving for short-term goals, such as a down payment for a car.

Individual investment goals, time horizon, and risk tolerance should ultimately guide the decision to invest in debt mutual funds. Nevertheless, for those seeking stability and income, debt funds can play a pivotal role in constructing a well-balanced investment portfolio.

Benefits of Investing in Debt Funds

There are 5 main advantages of investing in debt funds. They are listed below.

1. Regular Income

   Debt funds can help generate a regular income for investors that can supplement their earnings.

2. Stability during stock volatility

   Debt funds tend to maintain their value even during periods of heightened stock market volatility and crashes. Their fixed rates of return contribute to price stability, adding diversification to an investor's portfolio.

3. Diversification

   By investing in debt funds, investors can diversify their portfolios, reducing the risk associated with market-linked and high-risk assets.

4. Accessibility

   Debt funds enable retail investors to access debt instruments like commercial paper, certificates of deposit, and bonds that are typically available only to institutional investors due to their large ticket sizes. Debt funds package these instruments in an affordable and easy-to-invest format.

5. Short term goals

   With their low risk and predictable returns, debt funds are ideal for short-term financial goals such as saving for a down payment, funding a child's education, or building an emergency fund.

Things to consider before investing in debt funds

• Risk Factor

  Debt funds are open to risks such as credit risk, interest rate risk, etc. It would help if you looked at the extent to which your debt funds will be affected in such scenarios.

• Returns

  The debt fund returns tend to decline when the interest rate moves upwards and offer better returns when the interest rate is down. The difference in the debt fund returns will be much more significant for debt funds with longer maturity papers than the debt funds with instruments that mature within a shorter span of time.

• Cost

  Every mutual fund, including debt mutual funds, has an expense ratio. The expense ratio is the annual fund management fee. A higher expense ratio reduces the fund's returns.
  
  Investment time horizon
  Investors should invest in the debt funds that align with their time horizon and financial objectives.

Taxation of debt mutual funds

From 1st April 2023, all capital gains earned on debt funds are classified as short-term capital gains. Therefore, these are added to the income and taxed at the investors’ applicable tax slabs. The indexation benefits are no longer available on debt funds.

Other than capital gains, debt mutual fund investors can get income through dividends distributed by the fund if they have opted for the IDCW option. Dividends were previously taxed at source by the distributing corporation, with the remainder being passed on to the investor. However, after the 2020 budget, dividends are taxed at the investor's marginal rate, based on their income tax bracket. Dividend income would be taxed appropriately in the investor's taxable income.

Debt mutual funds provide a simple way to help investors invest in the debt market. After analysing factors like risk tolerance, financial objectives, etc. one should only invest in the best suitable debt funds.

Also read about : What are Equity Funds?

Types of Debt Funds

Debt funds come in various categories to cater to different investment needs:

Maturity based funds

Every debt investment has to mature on some day and return the principal investment and the final interest to the lender. Based on the average maturity (for different investments) of the portfolio, we get the maturity based fund types.

1. Overnight fund – literally overnight

2. Liquid Fund – Upto 91 days

3. Money market fund –12 months

4. Gilt Funds with 10 year constant maturity

Duration based funds

Duration is the measure of interest rate risk and is mentioned in no. of years. It is not too difficult to understand. If for example, a debt fund has a duration of 1, it means that for every 1% change in interest rates, the value of the fund will change by 1% too, though in the other direction. If the interest rate rises, the value will fall and vice versa.

1. Ultra Short Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 -6months

2. Low Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 6-12 months

3. Short Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 1-3 year

4. Medium Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3-4 years*

5. Medium to Long Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 4-7 years#

6. Long Duration Fund – Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is 7 years plus

7. Dynamic Bond – Investment in Debt & Money Market instruments across durations
   
   *SEBI allows the fund to run 1 to 4 years under adverse condition
   #SEBI allows the fund to run 1 to 7 years under adverse condition

8. Floater Fund- It holds investments that are frequently reset to the current market interest rates i.e. it invests 65% or more in floating rate instruments

Credit Quality

Another risk that debt funds may carry is the credit quality or the likelihood of repayment by the issuer. Based on credit quality here is how the new debt fund types look.

1. Banking and PSU Fund – 80% or more in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions and Municipal Bonds, typically high rated

2. Corporate Bond Fund – 80% or more in high credit rating investments (AA+ or higher)

3. Government Securities Fund or GILTs – holds 80% or more of Government securities (Sovereign rating)

4. Credit Risk Fund – has most holdings (65% or higher) in lower credit rated investments (AA and below)

By understanding the diverse types of debt funds available, investors can select the one that aligns best with their financial objectives and risk tolerance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.