What is a Debt Fund?
Debt funds are mutual funds that invest in money market and debt securities to generate returns for the investors. These funds may invest in the securities/ bonds issued by sovereign entities, banks, corporates, Public Sector Undertakings (PSUs), etc. depending upon the specific categories of debt funds' investment objective. Debt funds can be broadly classified into duration funds, money market funds, gilt funds, and credit opportunities funds.
Benefits of investing in debt funds
Lower Portfolio Volatility
As debt mutual funds invest primarily in debt and fixed income securities, the portfolio would generally reflect lower volatility depending upon the interest rate movements and changes in the issuers' credit profile.
Professional Fund Management
Like other mutual funds, debt funds allow professional fund management for the invested money. When investing directly in bonds, etc., one may need to track the different events impacting issuer entities regularly. With investments in mutual funds, this responsibility is assumed by professional fund managers.
Special Rates of Taxation for Long Term Capital Gains
Income tax laws provide a special tax rate of 20% from capital gains from debt funds if such investments have been held for 36 months or more. The benefit of indexation is also allowed on such capital gains, thereby further lowering the effective tax rate.
How do debt funds work?
Debt funds aim to generate returns primarily through the accrual of interest income from the investment portfolio's debt securities. While the interest income may be payable periodically by the securities in the investment portfolio, the interest income accrues daily on such securities. Such accrual also gets factored in the portfolio valuation suitably. The portfolio valuation may also vary depending upon the changes in macroeconomic factors, e.g., market interest rates, etc. and credit quality of the investment portfolio. As such, the returns from debt funds can be generated through accrual income and from the portfolio valuation changes due to changes in market interest rates and credit profiles of issuer entities.
Who should invest in Debt Funds?
The investors looking to allocate a part of their investment portfolio to debt asset class can consider investing in debt funds. Further, investors with a low-risk appetite can also invest in debt funds for portfolio stability with reasonable returns. One may align their investment strategy with the suitable mutual fund schemes by choosing from different debt funds available for the investors.
Risks in Debt Funds
Interest Rate Risk
It refers to the risk of the changes in the investment portfolio due to interest rate movements. When the market interest rates change, the existing securities issued at higher coupon rates may become more attractive and vice versa.
This causes the valuation of debt securities to move in the opposite direction, as the market yield and price of debt securities are inversely proportional to each other. Fund managers manage the interest rate risk by managing the fund duration.
It refers to the risk of default by the issuer entity. In simple words, it can be termed as the probability of the issuer entity not being able to honor its debt servicing obligations on time. It is measured through the investment portfolio's credit profile, broadly gauged through credit ratings issued by the Credit Rating Agencies. Such risk is mitigated by selecting debt securities based on internal research and due diligence about the issuer entity's creditworthiness, aided by the regular portfolio monitoring.
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