Debt mutual fund scheme: Types and how they work

Investing in fixed-income instruments can be a suitable way of building a diversified portfolio and generating regular income. The debt market offers various instruments facilitating the exchange of loans for interest. Since they are relatively less risky than equity investments, debt securities attract investors with a lower risk tolerance.

However, it is important to note that, despite offering potential stability, debt investments generally yield lower returns than equity. This guide simplifies debt fund investments, helping you understand their mechanics, potential uses, and key factors to consider before investing.

• Table of contents

1. Reasons for investing in debt mutual funds
2. Features of debt mutual funds
3. How does a debt fund work?
4. Using debt funds for specific goals
5. Types of debt funds
6. Why Should You Invest in a Debt Mutual Fund?
7. Factors to consider before investing in debt funds
8. Taxation Rules of Debt Funds
9. New amendment and its impact
10. How proposed changes would impact tax outflow
11. How to invest in debt mutual funds on the Bajaj AMC platform?
12. How to diversify portfolio with debt funds?

Reasons for investing in debt mutual funds

Here’s why including debt funds in your investment portfolio makes sense:

BConsistent returns: Debt funds offer relatively stable returns with lower sensitivity to market ups and downs compared to equity funds. They provide a relatively steady income stream, adding stability without the high risk of equities.

Liquidity: Debt funds can be redeemed anytime without a lock-in period. This flexibility makes them suitable for building an emergency fund to tackle unexpected financial needs.

Regular income: With debt funds, you can generate regular income through options like Systematic Withdrawal Plans (SWP), allowing you to withdraw money as needed by selling fund units.

Features of debt mutual funds

Debt mutual funds invest in bonds, government securities, and commercial papers. They provide professional management and diversification for investors. Key features include:

Expert management: Benefit from skilled fund managers who understand debt markets. Liquidity: Easily redeemable at any time.

Liquidity: Easily redeemable at any time.

Diversification: Spread investment across various fixed income securities.

Variable returns: Potential for different returns based on securities' performance.

Risks: Include credit risk from varying issuer creditworthiness and interest rate fluctuations impacting fund performance.

How does a debt fund work?

Debt funds allocate their investments to fixed-income securities such as treasury bills, corporate bonds, commercial papers, and government securities. These instruments represent loans extended to entities like governments, companies, or banks. Thanks to the predetermined maturity dates and interest rates, debt funds offer a potentially stable income upon maturity, earning them the label of fixed-income securities.

Typically, debt returns are less affected by market fluctuations than equity, thus making them a popular low-risk investment choice. Investors earn returns in two main ways:

Interest payments: The issuer of the debt instrument pays regular interest, which is distributed to investors

Capital appreciation: When the fund sells the debt instruments before maturity, the sale price may be higher or lower than the purchase price. This difference adds to or subtracts from the investor's initial investment. An increase to the initial investment is called capital appreciation.

Using debt funds for specific goals

The diversity within fixed income fund investments make them suitable for various goals:

Short-term goals: Liquid funds offer high liquidity and relatively low risk, making them suitable for parking savings for upcoming expenses.

Regular income: Income funds invest in fixed-income instruments with regular interest pay-outs, providing a potentially steady income stream.

Long-term wealth creation: Long-duration and credit risk funds offer a higher return potential but also greater risk. They are suitable for long-term goals like retirement.

Types of debt funds

Debt fund investments offer several options and can cater to various needs and risk-tolerance levels. Let's look at some of the types of debt funds:

Liquid funds: Liquid funds are a relatively stable and liquid investment option. They primarily invest in short-term debt instruments with a maturity of up to 91 days.

Ultra-short duration funds: These funds invest in debt instruments with a slightly longer maturity period than liquid funds, such that the Macaulay duration is between 3 to 6 months.

Short-term debt funds: If you're looking for investments with a horizon of 1-3 years, short-term debt funds can be a suitable choice. They invest in a mix of short to medium-term debt securities.

Dynamic bond funds: Dynamic bond funds are actively managed debt funds that adjust their portfolio duration based on interest rate expectations. This flexibility allows them to potentially capitalize on interest rate movements and generate relatively higher returns.

Why Should You Invest in a Debt Mutual Fund?

Relative stability and predictability

Debt funds offer a level of relative stability and predictability that can be comforting, especially for those with lower risk tolerance. Unlike equity investments, which can be highly volatile, debt funds aim to mitigate impact on capital.

Relatively steady cashflow

If you're looking to generate a potentially steady cashflow from your investments, debt funds can be a suitable option. Many debt funds distribute Income Distribution cum capital withdrawal (IDCW) at regular intervals, such as monthly, quarterly, or semi-annually.

Liquidity

Debt funds offer liquidity that is often superior to traditional fixed deposits. You can redeem your investment partially or fully at any time, depending on the fund's terms and conditions.

Diversification

A well-diversified investment portfolio helps spread risk. By investing in debt funds alongside equity and other asset classes, you can achieve better diversification.

Professional management

Debt funds are managed by experienced fund managers who make investment decisions based on thorough research and analysis. These experts analyse market conditions, interest rate movements, and credit quality to optimize the return potential. Professional management of the fund can be beneficial, especially if you lack the time or expertise to manage your investments actively.

Inflation hedge

While debt funds may not provide the same potential for wealth creation as equities, they can serve as a hedge against inflation.

Risk management

Different types of debt funds offer varying risk levels , allowing you to tailor your investments to your risk tolerance. If you prefer low-risk options, you can opt for liquid funds or gilt funds. Conversely, if you're willing to take on more risk for potentially better returns, credit opportunities or dynamic bond funds may be more appealing.

Convenience and accessibility

Investing in debt funds is hassle-free. You can start with relatively small amounts, often as low as Rs. 1,000, and the process can be done either through a distributor, or online through various fund houses and investment platforms.

To conclude, debt funds offer an attractive proposition for investors seeking relative stability, cashflow, and diversification. Whether you're saving for a short-term goal, building an emergency fund, or balancing your portfolio with a mix of asset classes, debt funds can play a valuable role in achieving your financial aspirations.

Factors to consider before investing in debt funds

So, how do you choose which debt fund to invest in? Some key deciding factors include:

Investment horizon: Match your chosen fund's maturity with your investment goal to avoid potential penalties for early withdrawals.

Risk tolerance: Choose funds that align with the risk level you are comfortable with. A higher return potential usually comes with a higher risk. Longer duration debt funds also tend to carry a higher risk.

Expense ratio: Compare the fund's management fees to understand its impact on your returns.

Debt funds are advisable for investors with lower risk tolerance. These funds typically invest in various fixed-income securities to provide a relatively stable return potential.

Taxation rules for debt funds

The taxation pattern for debt funds was changed in Union Budget 2023 and 2024. Here is the current tax structure:

For units purchased before April 1, 2023:

Short-term capital gains (STCG) are applied to debt funds redeemed within 24 months of purchase and taxed at the applicable slab rates.

Long-term capital gains (LTCG) are applied to funds held for more than 24 months and taxed at 12.5%.

Units purchased on or after April 1, 2023:

Gains from all debt funds are considered short-term capital gains, regardless of the holding period, and are taxed at the applicable slab rates.

Indexation benefits are no longer available for these investments.

New amendment and its impact

From April 1, 2023, onwards, capital gains earned from debt mutual funds, exchange-traded funds (ETFs), international funds, gold funds, and specific categories of hybrid funds that invest less than 35% in Indian equities will be included in your taxable income and subject to taxation at the applicable slab rate, irrespective of the holding period. The previously available long-term capital gains (LTCG) tax benefits and indexation benefits on debt mutual funds will no longer be applicable.

Debt funds and equity funds usually have a minimum of 65% of their investments in debt securities or equities, respectively. However, as per the new tax rule, non-equity funds with less than 35% of investments in equities will no longer be eligible for the long-term capital gains (LTCG) tax rate of 20% with indexation, effective from April 1, 2023. This tax advantage was a significant reason why many investors preferred debt investments, but it is no longer available.

However, till Budget 2024, the indexation benefit was applicable to units purchased before April 1, 2023. That is no longer the case. Now, units purchased before April 1, 2023, will be eligible for long-term capital gains tax after a holding period of 24 months (instead of 36 months). The LTCG tax rate will be 12.5% (instead of 20% with indexation).

The indexation benefit on hybrid funds investing more than 35% but less than 65% in Indian equity was also removed. For this category, gains on units held for less than 24 months will be taxed as per the slab rate. Gains on units held for more than 24 months will be taxed at 12.5%.

For debt fund units purchased after April 1, 2023, there is no change. These units will be added to the investor’s annual income and taxed as per the applicable slab rate.

How proposed changes would impact tax outflow

Tax efficiency plays a significant role in driving investment decisions across various avenues, including insurance, bonds, mutual funds, equities, NPS, PF, and alternative investments. Investors tend to prefer avenues with lower taxation on returns. Therefore, the changes to capital gains taxes on certain hybrid mutual funds and all debt mutual funds may affect their attractiveness to investors. However, their return potential and liquidity advantage may still make them more attractive than other avenues such as savings accounts, short-term fixed deposits, and recurring deposits.

How to invest in debt mutual funds on the Bajaj AMC platform?

To invest in a Bajaj Finserv AMC debt mutual fund, follow these steps:

1. Browse the website and choose a scheme that fits your investment goals.

2. Click on ‘Invest Now’ on the scheme page or home page, which will redirect you to the investor portal.

3. Log in if you are an existing investor or sign up by providing your name, date of birth, PAN details, and bank account information. If you’re not KYC verified, complete the KYC process.

4. Select your scheme and investment mode (lumpsum or SIP) from the dropdown menu. Enter your investment amount and choose your payment method.

How to diversify portfolio with debt funds?

Assess risk tolerance and investment goals: Determine your risk tolerance and investment horizon to identify the proportion of debt funds suitable for your portfolio.

Selecting the right debt funds: Choose debt funds aligned with your investment goals. Consider factors such as fund type, credit quality of underlying securities, expense ratio, and historical mutual fund performance.

Allocation strategy: Decide on the allocation percentage for debt funds in your portfolio based on your risk profile. A more conservative investor might allocate a higher percentage to debt funds for relative stability.

Periodic review and rebalancing: Regularly review your portfolio's asset allocation and rebalance if necessary to maintain the desired mix of equity and debt funds.

Diversification across debt categories: Consider diversifying within debt funds by investing across different categories like liquid funds, short-term funds, and gilt funds to spread risk.

Conclusion

Debt funds aren't just a stable option for parking surplus cash. They offer options for short-term needs, regular income generation, and long-term wealth creation. Understanding their diverse types, considering your goals and risk tolerance, and making informed choices can unlock the potential of debt funds and pave the way for a financial stable future.

FAQs

Is there any lock-in period for debt funds?

No, debt funds do not have any lock-in period and can be redeemed easily within 3 business days of placing the redemption request.

Who should invest in debt funds?

Debt funds usually carry relatively low risk. So, conservative investors with low risk appetite can consider investing in debt funds. Also, individuals who are new to the market can consider making debt funds a part of their portfolio before beginning to invest in equity funds. This can help them earn steady returns without being too concerned about market volatility.

Are debt funds risk-free?

Although debt funds are less risky than equity funds, they aren’t completely risk-free. As there are many types of debt funds, the level of risk depends on the average maturity of the specific portfolio.

What are the key differences between debt funds and equity funds?

Debt funds generate returns through fixed income, while equity funds invest in company stocks and aim for capital appreciation through company growth.

What are the main risks associated with debt fund investments?

Interest rate fluctuations, credit risk of issuer default, and fund management risks can impact returns from debt funds.

Which is better, FD or debt mutual fund?

Choosing between Fixed Deposits (FDs) and debt mutual funds depends on your financial situation, liquidity needs risk tolerance, and goals. FDs offer guaranteed, low-risk returns. Debt funds are relatively stable, but not risk-free. Their return potential may be higher than that of FDs of a similar maturity period as the debt funds’ portfolio duration, but it depends upon market conditions. However, open-ended debt funds are typically quite liquid, allowing investments, redemptions and part-redemptions at any time.

Are debt funds taxable?

Yes, debt mutual funds are taxable in India. Capital gains on units purchased after April 1, 2023 are added to the investor’s annual income and taxed as per their prevailing tax slab.

Which debt funds are least risky?

The risk level of a debt fund depends upon the credit quality and duration of their underlying securities. Overnight funds (which invest in securities maturing overnight) are usually considered low risk because they entail minimal interest rate risk.

Can I withdraw debt funds anytime?

You can usually withdraw from most debt mutual funds anytime, unless they are close-ended. These funds are liquid, meaning you can redeem your units within a few business days. Some funds may charge an exit load if withdrawn early, but many debt funds don’t have such a fee.

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 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.