What are the different types of debt funds in India?

The various types of debt mutual funds available for investments in India play a crucial role in investors’ portfolios, providing a relatively better return potential while seeking to minimize risks associated with the volatile equity market. While the different types of debt funds cater to a wide range of investment objectives and risk appetites, it's essential for investors to align their investment goals and risk tolerance with a suitable scheme.

This article details the different types of debt funds you can consider.

• Table of contents

• Few examples of debt funds
• Taxation
• Why invest in debt mutual funds?
• Risks associated with debt funds

Few examples of debt funds

• Liquid funds: Liquid funds are a relatively stable and liquid investment option. They primarily invest in short-term money market instruments, such as treasury bills and certificates of deposit with up to 91 days maturity. Investors seeking relative stability and easy access to funds often opt for liquid funds.
• Ultra-short duration funds: These funds have a slightly longer investment horizon compared to liquid funds. They invest in short-term debt securities, offering a slightly reasonable return potential compared to liquid funds. Ultra-short duration funds are suitable for investors with a short to medium-term investment horizon.
• Short duration funds: Short duration funds invest in a mix of short to medium-term debt instruments. They aim to strike a balance between returns and risk. These funds can be considered by conservative investors looking for relatively reasonable returns.
• Medium duration funds: Investors with a moderate risk appetite can consider medium duration funds. These funds invest in a mix of medium-term debt securities, offering a potentially higher yield compared to short-duration funds albeit at a higher risk.
• Long duration funds: Long duration funds are tailored for investors with a longer investment horizon. They primarily invest in long-term government and corporate bonds. While they offer the potential for higher returns, they are also subject to interest rate risk.
• Credit risk funds: Credit risk funds invest in lower-rated corporate bonds, offering the potential for higher returns. However, these plans are associated with a higher credit risk, making them suitable for investors with a higher risk tolerance.
• Dynamic bond funds: Dynamic bond funds have the flexibility to invest across the entire duration spectrum, allowing fund managers to adapt to changing market conditions. These funds aim to potentially optimize returns by actively managing the portfolio.
• Fixed maturity plans (FMPs): FMPs have a fixed investment tenure and primarily invest in debt instruments with a similar maturity profile. They offer potentially reasonable returns.

Also Read: Liquid funds vs debt funds - What is the difference?

Taxation of debt mutual funds

Debt mutual funds in India are now taxed based on the investor’s income tax slab, following the removal of indexation benefits on long-term capital gains tax in 2023.

Now, all capital gains from debt mutual funds are deemed to be short-term capital gains. The gains are added to the income of the investor and are taxed at their applicable tax slab rate.

Why invest in debt mutual funds?

Debt mutual funds can be suitable for investors seeking the potential for relatively stable returns and income. Here are some of their advantages:

• They can potentially provide regular income.
• They can help with portfolio diversification.
• They offer higher liquidity and similar or better return potential than fixed or recurring deposits.
• They offer better return potential than savings accounts. However, savings accounts offer capital stability and fixed returns, unlike mutual funds.

However, while debt funds are less volatile than equity funds, they are not without risk.

Risks associated with debt funds

Debt funds are subject to multiple risks that investors should consider.

• Credit risk: The possibility that the issuer of a debt security may default.
• Interest rate risk: The potential for bond values to fluctuate due to changes in interest rates.
• Liquidity risk: The risk that some securities may not be easily sold when needed.
• Reinvestment risk: The possibility that interest payments may be reinvested at lower rates.

Also Read: Debt mutual fund scheme: Types and how they work

Conclusion

Debt mutual funds may be an option for investors looking for a relatively stable investment avenue. However, taxation rules and potential risks must be carefully evaluated. Debt funds can generate potential returns but also carry associated risks. The revised tax regulations mean returns are taxed according to the investor's income tax slab. Investors should assess their risk tolerance and consult a financial advisor before investing.

FAQs

Are debt mutual funds risk-free?

Debt mutual funds are not without risk. They are subject to credit risk (possibility of issuer default), interest rate risk (bond prices may fluctuate with changing rates), and liquidity risk (difficulty in selling holdings when needed). However, they tend to be less volatile than equity funds.

Who invests in debt funds?

Debt funds are commonly chosen by investors seeking the potential for steady income and lower volatility than equity funds. This can include conservative investors, retirees, and individuals looking for an avenue to park funds for the short term. Corporations and institutions also allocate money to liquid or overnight funds for cash flow management.

Should you invest in a short-term debt fund?

Short-term debt funds can be beneficial for investors needing a place to park funds for a few months to a year. These funds usually have lower interest rate risk than long-term debt funds. However, they still carry some risk. Their return potential is also typically lower than that of long-term debt funds.

Which type of debt fund is suitable for short-term investment?

For short-term investments of a few months to a year, options such as low duration funds, short duration funds and money market funds can be considered. These funds invest in debt instruments with shorter maturities, which may help reduce interest rate risk. For very short-term investments or to park surplus cash, overnight funds and liquid funds can be considered.

What factors should I consider before investing in a debt fund?

Key factors to consider include credit risk (issuer's repayment ability), interest rate risk (effect of rate changes on bond prices), duration (sensitivity to interest rates), expense ratio, and liquidity. Additionally, these funds have lower return potential than equities, so they may not be suitable for long-term goals that need the potential for inflation-beating returns.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.