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Debt Funds are a kind of Mutual Funds that generate returns by lending your money to the government and companies. The lending duration and the kind of borrower, determine the risk level of a Debt Fund.
- Debt Funds can be considered for an investment horizon of 1 day to up to 3 years
- They offer better post-tax returns compared to FDs if you stay invested for at least 3 years
- Liquid Debt Funds are a great option to park your emergency funds. You can earn better returns than savings bank account without taking too much risk
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Types of Debt Funds
Park Your Savings
Overnight
For up to 1 week
Liquid
For 1 week to 1 month
Ultra Short Duration
For 2 to 4 months
Low Duration
For 3 to 9 months
Money Market
For 6 to 12 months
Index
Long-term passive funds for debt investments
By Solutions
Retirement Solutions
Invests primarily in debt papers for retirement solutions
Better than FDs
Banking and PSU
Lends only to Banks & PSUs
Corporate Bond
Lends to Safe & Sound Companies
Short Duration
For 1 to 3 years
Others
Credit Risk
Invest at least 65% in not-so-highly rated securities
Gilt
Invests primarily in government securities
Gilt with 10 year Constant Duration
Invests passively in government securities.
Floater
Invests at least 65% in floating rate-bonds
Debt FoF
Invests in other debt funds
Debt for Long Term
Medium Duration
For 2 to 4 years
Target Maturity
Index funds for debt investments
Medium to Long Duration
For 3 to 5 years
Long Duration
For 5 years or more
Dynamic Bond
Lends based on interest rate movements
Best Performing Debt Mutual Funds
| Scheme Name | Expense Ratio | 1Y Return | ||
|---|---|---|---|---|
| HDFC NIFTY G-Sec Jun 2036 Index Fund | 0.2% | 9.4% p.a. | Invest Invest on App |
| BHARAT Bond ETF FOF - April 2033 | 0.06% | 9.38% p.a. | Invest Invest on App |
| UTI CRISIL SDL Maturity April 2033 Index Fund | 0.16% | 9.22% p.a. | Invest Invest on App |
| Edelweiss CRISIL IBX 50:50 Gilt Plus SDL April 2037 Index Fund | 0.2% | 9.2% p.a. | Invest Invest on App |
| Kotak Nifty SDL Jul 2033 Index Fund | 0.2% | 9.18% p.a. | Invest Invest on App |
| Bandhan CRISIL IBX 90:10 SDL Plus Gilt- April 2032 Index Fund | 0.16% | 9.16% p.a. | Invest Invest on App |
| Kotak Nifty SDL Apr 2032 Top 12 Equal Weight Index Fund | 0.2% | 9.15% p.a. | Invest Invest on App |
| Kotak Medium Term Fund | 0.63% | 9.11% p.a. | Invest Invest on App |
| Aditya Birla Sun Life CRISIL IBX SDL Jun 2032 Index Fund | 0.23% | 9.02% p.a. | Invest Invest on App |
| Nippon India Nifty G-Sec Jun 2036 Maturity Index Fund | 0.2% | 8.96% p.a. | Invest Invest on App |
All about Debt Mutual Funds
How do Debt Funds work?
Who should invest in debt funds?
Things to consider before investing
Taxation
How do Debt Funds work?
- Sources of Returns: A debt fund earns in two ways. First, interest payments from its bond holdings generates coupon or accrual income. Second, when interest rates change, bond prices move in the opposite direction, resulting in capital gains or losses on the fund portfolio. When market yields go up, bond prices decline and the value of the fund declines. When market yields fall, bond prices increase, and the value of the fund goes up. The capital gain/loss component is also called the mark-to-market (MTM) return. How much a debt fund earns through interest and how much through capital gains depends on the type of bonds held by it.
- Capital Gains and Interest Earnings: Capital gains depend on the average maturity of the bonds held by fund. When market yields fall, prices of long-term bonds increase more than prices of short-term bonds. This means that funds with higher average maturity show a higher increase in net asset values. In contrast, when market yields rise, funds with higher average maturity see a steeper decline in valuation. So funds that hold more long term bonds are more likely to make capital gains or losses. In market jargon, we say that funds with higher duration carry a higher mark-to-market (MTM) or interest rate risk.
Debt funds that are mainly invested in short term bonds show limited capital gains and losses. They earn mainly through interest payments. Such funds can increase yields by holding lower rated bonds. That is because bonds with a lower credit rating, which are more likely to default, have to pay higher coupon rates as compared to bonds with a better rating. - Strategies to Manage Returns Debt funds manage returns by varying the maturity profile or credit rating of their bond portfolios. Funds with higher exposure to long term debt can make strong capital gains when rates are falling, but could generate massive losses when rates are going up. In contrast, funds that invest mainly in short-term securities like money market debt or treasury bills have stable NAVs, but do not benefit from capital gains. On the credit side, holding AAA or AA+ debt ensures safety of principal, but is likely to keep yields to the minimum. A higher exposure to lower-rated bonds may push up coupon income but also increases credit risk. Thus, the best performing debt funds have to make smart and well-researched interest rate and credit calls to manage risk and deliver outstanding returns.
Who should invest in debt funds?
- Investors seeking Regular income: Debt funds that invest in high-quality bonds or keep durations low are ideal for risk-averse investors looking for steady income, such as retired persons.
- Conservative or First-time mutual fund investors: Conservative or first-time mutual fund investors, who do not want to take on the risk of investing in equity funds, can consider short duration funds or corporate bond funds, as a replacement for bank fixed deposits. Along with liquidity and flexibility of withdrawal, the debt fund investment is likely to generate higher returns, especially when interest rates are declining.
- Investors who want to purchase equity in a bearish market: Even an aggressive equity investor can benefit by combining a debt fund with a Systematic Transfer Plan (STP). For example, an STP from a debt fund to an equity fund will minimize average cost in a sideways or bearish market; because the STP will allow periodic transfers from the debt fund to purchase units of the equity fund.
- Investors who want to park short-term funds: Households and businesses can deploy short-term surpluses in liquid or ultra-short duration funds rather than leave them in a bank deposit. An overnight or liquid fund can even hold household emergency funds while earning a modest return. Investors with a specific investment horizon can opt for an FMP.
Things to consider before investing
- Debt funds are among the least risky mutual funds, but investors must keep in mind that like all mutual funds, they are market-linked products. There are no guaranteed returns, and even the best performing debt funds are exposed to interest rate risk and credit risk. Interest rate risk depends on market interest rates, over which fund managers have limited control. An unexpected increase in rates can wipe out months of capital gains, especially for a long-duration fund.
- Credit risk arises due to the possibility of default on interest and principal payments by the bonds held by the debt fund. The IL&FS downgrade and resulting value erosion for some debt funds have made it clear that even liquid funds are not exempt from the consequence of credit default. Investors can minimize risk by evaluating fund parameters carefully, sticking to best performing funds with a proven track record, and by making sure that their risk-return expectations are aligned with the debt fund's investment objective.
Taxation
- Investors can earn dividends and capital gains from debt funds. Capital gain is the difference between the price at which units were purchased and the price at which they were redeemed or sold.
- How capital gains are taxed depends on the length of time for which an investor holds the units of a mutual fund. If an investor stays invested in a debt fund for a period up to 3 years, capital gains on redemption/sale are considered as short-term capital gains and taxed at the income tax slab rate applicable to the investor.
- However, if the debt fund is redeemed/sold after being held for more than 3 years, it is considered as long-term capital gain and the investor gets the benefit of "indexation". This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. Long-term capital gains are currently taxed at a rate of 20%.
- Here is a simple example to explain this concept. Suppose Amit invested ₹100 in a debt fund in FY 2014-15 and sold it for ₹160 in FY 2018-19. Since Amit was invested in the fund for more than 3 years, he has earned long-term capital gains on the sale of his units. The Cost Inflation Index (CII) in FY15 and FY19 were 240 and 280 respectively. For tax purposes, Amit's purchase price will be increased to (280/240) x 100, or ₹117, and taxable long-term capital gain will be 160 - 117 = ₹43. The tax payable is 20% of ₹43, or ₹8.60.
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Frequently asked questions
What is a debt fund with an example?
Debt Funds are types of Mutual Funds that generate returns by lending your money to the government and private companies. For example, Banking and PSU Debt Funds lend to Banks and Public Sector Units only.
Are debt funds risk-free?
There are Debt Funds with negligible or near-zero risk. Overnight Funds and Liquid Funds are examples of Debt Funds with extremely low. However other Debt Funds categories do carry risk. So always check before investing.
Which debt fund is best?
Selecting the best debt fund will depend on your investment horizon. If you want to invest for 1 day to up to a month then opt for Overnight Funds or Liquid Funds. For up to 6 months, Ultra-Short Duration Funds. For 6 months to 1 year time period, Money Market funds. And if the investment horizon is between 1 year and 3 years, you can go for Corporate Bond Funds, Banking & PSU Bond Funds, or Short Duration Bond Funds.
Is it good to invest in debt funds?
Investing in debt funds is a good option when you want to preserve your capital and at the same time want to earn better post-tax returns than FDs. It is also a good option to fulfill your near-term goals.
Is it good to invest in a short-term debt fund?
Yes, it is good to invest in short-term debt funds. In fact, it is advisable to invest in short-term debt funds for your near-term goals, as the value of long-duration funds is likely to fall more when there is an increase in interest rate.
Which debt funds are safe?
Overnight Fund is the safest among debt funds. These funds invest in securities that are maturing in 1-day, so they don't have any credit or interest risk and the risk of making a loss in them is near zero. Liquid Funds are also among the safest categories, as they can only invest in debt and money market securities with maturities of up to 91 days. This reduces the interest rate risk and credit risk that these funds can take.
How do I choose a debt fund?
First, decide your investment horizon. This will help you select the right Debt Fund category. The next step is to pick a fund from the category. Go for a fund that lends to good companies and has a lending duration similar to your investment duration.
Do debt funds have a lock-in period?
No, debt funds do not have a lock-in period. Apart from higher post-tax returns, this is another advantage that debt funds have over FDs.
