When it comes to mutual fund investments, most often investors think of equity-oriented mutual funds. While equity mutual funds are certainly popular, there are several other types of mutual fund schemes like debt funds, liquid funds, index funds and more. By investing in debt funds, investors can diversify their portfolio while minimizing risks.
Here, in this guide, we share with you all that you need to know about debt funds – what is it, how do they work, benefits, features, the top-performing debt funds, how to choose the right debt funds and more.
What is a debt fund?
A debt fund is a type of mutual fund scheme. The fund allocates investments in fixed market instruments like government securities, corporate bonds, debentures, commercial papers, treasury bills, certificates of deposits and other money-market instruments.
Since these fixed-income securities have lower risks when compared to stocks, the overall risk levels of debt funds are significantly lower than that of equity-oriented mutual funds. Hence, debt funds are ideal for investors who wish to invest in mutual funds but don’t want the high market risks associated with equities.
One common question investors have, "why is this fund called debt?" It's because issuers of debt instruments like government securities, corporate bonds and others borrow money from lenders against these instruments. Debt instruments come with varying maturity periods and can either generate income at regular intervals or on maturity.
Debt instruments generally require higher investment capital, making it out of reach of retail investors. As a result, debt mutual funds are the ideal option for individual investors who are looking to add debt instruments to their portfolio. You can add debt instruments to your investment portfolio, even with small amounts.
How do debt funds work?
Debt funds purchase money-market instruments using the funds of investors and earn interest on these investments. It is sort of similar to the working of a fixed deposit. When you open a fixed deposit in a bank, the bank lends your money to borrowers. In return, the bank earns interest on it, which is then shared with you.
In a debt fund, the fund manager uses the funds of investors to purchase money-market instruments like corporate bonds, government securities, and so on. The yields from these instruments are the earnings of the investor.
The actual working of debt funds is a bit more complicated. For instance, certain funds can purchase only securities that mature at specific periods. To give a few examples, liquid funds can invest only in securities that mature within 91 days, whereas gilt funds can only purchase government bonds and so on.
However, unlike FDs, debt funds do not offer guaranteed returns. The returns earned by debt funds are market-linked and hence can fluctuate. Rising interest rates generate higher interests while falling interest rates can impact the overall profits earned.
Who should invest in debt funds?
Debt funds are ideally suited for:
Investors with low to moderate risk profile
Investors who want to park their surplus funds for the short-term
Investors who wish to enjoy the benefits of diversification by adding debt instruments to their portfolio
Common Types of Debt Funds
There are several types of debt funds to suit the varying requirements of investors. Investors can choose the right kind of debt fund based on their investment goals, investment horizon and risk appetite.
Liquid funds invest in securities that have extremely short maturity period, not exceeding ninety-one days. Some common assets that liquid funds invest in include – commercial papers, treasury bills, and certificates of deposits.
Ideal for: Investors looking to park their idle funds for short periods.
Ultra Short-term Funds
These funds invest in securities that have a maturity period of 3 to 6 months. These funds invest in a variety of debt and money-market instruments.
Ideal for: Investors who are looking for cash management of their idle funds in the short-term.
Low Duration Funds
These funds invest in debt securities that have a maturity period of 6 to 12 months.
Ideal for: Investors looking to park their idle funds for six to twelve months.
Money Market Funds
As the name implies, these funds invest in money-market securities that have a maturity period of up to one year.
Ideal for: Investors with a low-risk appetite and who have surplus funds parked in bank fixed deposits.
Short-term Debt Funds
Short-term funds invest in government bonds and corporate bonds that have maturity periods ranging from one to three years.
Ideal for: Investors with low to medium risk appetites.
Medium-term Debt Funds
As the name implies, these debt funds have a portfolio duration of 3 to 4 years. These funds invest in a mix of government securities, corporate bonds and other money-market instruments.
Ideal for: Investors who are looking to benefit from falling interest rates.
Corporate Bond Funds
As the name implies, these funds invest up to 80% of the assets in corporate bonds that have a credit rating of AA+ and more.
Ideal for: Investors with moderate to high-risk profiles.
Credit Risk Funds
These funds invest up to 65% in corporate bonds that have a credit rating of AA and below.
Ideal for: Investors with high-risk profiles.
Banking and PSU Fund
As the name implies, these funds invest up to 80% of the total assets in debt instruments issued by public sector undertakings, banks, municipal bonds and other public financial institutions.
Ideal for: Investors with moderate to high-risk profiles.
These funds invest up to 80% of the total assets in sovereign securities issued by the central government or state governments. The primary goal of GILT funds is to generate risk-free returns for investors.
Ideal for: Investors with low to moderate risk profiles.
Besides these ten popular types of debt funds, there are several other lesser-known debt funds like floating rate funds, fixed-maturity funds, monthly income plans, and capital protection funds.
Investors can choose their preferred type of debt funds based on their investment horizon, risk profile and investment objective.
Why invest in debt funds?
Let’s take a look at some of the top benefits of investing in debt funds:
When compared with equity funds, debt funds are less volatile. Hence, they reduce the risk of losses.
Diversification of Portfolio
Investing a percentage of your capital in debt instruments helps you reduce the volatility of your equity investments.
Expose your Portfolio to Debt Instruments
As mentioned above, individual investors cannot usually invest in debt instruments due to the higher entry limits. With debt mutual funds, investors can add units of various debt instruments like government bonds, corporate securities, non-convertible debentures, treasury bills and other less common money-market instruments.
Earn Moderate Returns
By choosing the right debt funds, investors can not only enjoy capital protection but can also build their wealth, at prevailing rates of interest.
Enjoy an additional Source of Revenue
A particular type of debt fund like the monthly income plan provides investors with an additional source of revenue, in the form of dividends. Depending on the type of funds chosen, investors can receive these dividends – monthly, quarterly, semi-annually or annually.
Park Surplus funds in the Short-Term
Unlike equity mutual funds that do not work well for short-term investments, there are several types of debt funds that offer investors good returns, even in the short-term.
Factors to keep in mind while choosing Debt Funds
With different types of debt funds available in the market, finding the right debt fund that suits you is a significant challenge. Here are a few parameters to help you identify the best debt fund that suits your investment profile.
Before you choose a debt fund (or any mutual fund), you have to ask yourself this question – what is the reason for investment? Am I looking to build a retirement corpus, save for my child's education or creating an emergency fund?
Depending on your answer, you can choose the right fund that caters to your investment goals.
Depending on your investment objective, you will have a specific investment horizon. For instance, retirement planning has a more extended investment period compared to building emergency funds. Depending on the time frame, you can choose the right type of debt fund.
Though debt funds have lower risks compared to equity funds, it doesn't mean they are risk-free. Debt funds come with certain risks like interest-rate risks and credit risks. Credit risk occurs when your assets are allocated in securities with low credit ratings. Interest-rate risks happen when interest rates drop, leading to poor returns on investment. Hence, make sure to evaluate the historical fund performance and the track record of the fund manager before investing in a debt fund.
Expense Ratio and Exit Loads
Since debt funds have low returns, a large expense ratio could end up eating a significant chunk of your profits. Also, debt funds with huge exit loads can reduce your gains when you withdraw prematurely. So, make sure to compare the expense ratio and exit loads of different fund schemes before investing in a debt fund.
Mode of Investment
Generally, investments in debt funds can be made in one of the following two ways:
Lump-sum investments – As the name implies, in this method, the investor invest in debt funds at one go. It requires a significant corpus and is ideal for investors who have surplus funds in hand.
Systematic Investment Plan(SIP) – In this method, the investor invests small amounts of money at regular intervals. Since the amount invested is low (starts with just Rs. 500 per month), it's best suited for salaried individuals who cannot set aside a bulk sum for investment. The other benefits of opting for this investment method include:
Rupee cost averaging
Make sure to consider all these factors while taking a call on the selection of the right debt fund.
Best Debt Funds to Invest in India
|S.No.||Fund Name||3-Year Return||5-Year Return||Risk Level|
|1||Aditya Birla Sun Life Income Fund||7.60%||7.36%||High Risk|
|2||Franklin India Low Duration Fund||4.89%||6.82%||Moderate Low Risk|
|3||HDFC Short Term Debt Fund||8.07%||8.36%||Moderate Low Risk|
|4||Kotak Credit Risk Fund||7.66%||8.42%||Moderate Low Risk|
|5||SBI Magnum Medium Duration Fund||8.73%||9.07%||Moderate Risk|
*Note that returns from these funds are subject to change based on market fluctuations. Make sure to choose funds based on your investment goals.
Get Started with Debt Funds and Build your Wealth
If you’re worried about the volatility of the equity markets, then debt funds are the right choice for you. When compared with equity-oriented mutual funds, debt funds offer stable returns with limited market risks.
Make sure to understand the different categories of debt funds and choose the right scheme that best suits your investment objectives. With reasonable returns and capital appreciation, debt funds can help you build your wealth over time.