Debt Mutual Funds

Debt mutual funds are investment schemes that mainly focus on fixed-income securities. These include government bonds, corporate bonds, treasury bills, commercial paper, and other money market instruments. The fund manager distributes investor capital across the different fixed-income securities.  

Debt funds generate returns through two key ways – interest from the underlying securities and capital gains if the bond prices rise.  

Unlike equity funds that invest in company shares, debt funds concentrate on investing in instruments that pay fixed interest rates. The quality of the credit, maturity and sensitivity to interest rates of the underlying securities determine the risk-return profile of the fund. 

Types of Debt Funds

Now that we know what is debt mutual fund, let us look at these types. SEBI categorizes the debt mutual funds into various categories depending on their investment focus and duration:

1. Overnight Funds  
   Overnight Funds are used for investments with securities which have a maturity period of one day. These debt fund types are suitable for investors who require next day liquidity, with low interest rate risk and safety.
2. Liquid Funds 
   These funds hold debt and money market securities of up to 91 days of maturity. Fund managers usually invest in treasury bills, commercial paper, and certificates of deposit. Liquid funds provide a better interest rate than saving account.
3. Ultra Short Duration Funds
   These funds have Macaulay duration between three and six months. These funds invest in short-term debt instruments and money market securities.
4. Low Duration Funds
   Low duration funds contain securities with a Macaulay duration of six to twelve months. The portfolio typically includes corporate bonds, government securities, and money market instruments.
5. Money Market Funds
   Money market funds invest in money market instruments that mature within one year. These funds invest primarily in debt securities with shorter maturities and relatively lower interest rate sensitivity.
6. Short Duration Funds
   These debt fund types maintain Macaulay duration between one and three years. Portfolio managers select securities based on their credit quality and the interest rate outlook.
7. Medium Duration Funds
   These funds hold instruments with a Macaulay duration between three and four years. These debt fund types are moderately sensitive to interest rate changes. 
8. Medium to Long Duration Funds
   Medium to long duration funds have Macaulay duration between four and seven years. Interest rate changes greatly affect these categories.
9.  Long Duration Funds
   Long Duration Funds invest in securities with a Macaulay duration exceeding seven years. These debt mutual funds carry a higher interest rate and risk compared to shorter duration ones.
10. Dynamic Bond Funds
    Dynamic Bond Funds allow fund managers the flexibility to invest across different duration ranges based on interest rate views. The portfolio changes according to market conditions.
11. Corporate Bond Funds
    Corporate Bond Funds allocate at least 80% of their assets to corporate bonds. SEBI mandates investments only in bonds rated AA+ and above.
12. Gilt Funds
    Gilt Funds invest at least 80 percent of the investment in government securities of different maturities. These debt fund types are 0 credit risk funds, but are subject to changes in interest rates. 

How does a Debt Fund Work

Debt funds collect capital from multiple investors and use the money to invest in fixed-income securities. The fund house appoints a manager who builds and oversees the portfolio according to the scheme’s investment goals.

When an investor purchases units of a debt fund, the money is spent by the manager when he/she buys debt securities. These securities yield interest payable that is recorded in the fund on a day-to-day basis. The Net Asset Value (NAV) is the present value of all holdings divided by the outstanding units.

Fund managers assess the risk of credit default in order to make a judgement on whether issuers will default on their securities prior to purchasing their securities. They also look at interest rate trends to determine the best portfolio duration. Portfolio rebalancing happens periodically based on market conditions, liquidity needs, and credit quality changes.

The fund incurs costs for management fees, custodian charges, and other operational expenses. SEBI has set an expense ratio cap based on the assets under management. This expense ratio reduces the returns that investors ultimately receive.

Debt funds calculate NAV on all business days. Investors can buy or redeem units at the applicable NAV, subject to entry or exit loads noted in the scheme documentation. Some debt fund types have rules on exit loads to discourage short-term trading. 

How to Choose the Right Debt Fund Scheme?

Deciding on the type of debt fund depends on a number of factors that relate to individual financial circumstances:

• Investment Horizon
  The average maturity of the fund should be proportional to the period of investment. The shorter durations work well with the liquid funds or ultra-short duration funds. The longer horizons allow taking into account medium to long duration funds.
• Risk Tolerance
  Long duration funds are more risky than gilt funds or overnight funds. The evaluation of personal risk capacity can be used to reduce the appropriate categories.
• Interest Rate Outlook
  An increase in interest rates tends to affect long duration funds more adversely than category of shorter duration funds. The right duration is subject to market conditions.
• Liquidity Requirements
  Funds which have longer lock-in periods or higher exit loads are better suited for investors who don’t need immediate access to their capital.
• Expense Ratio
  Lower the expense ratio, the more returns will be passed to the investors. Comparing expense ratios of similar schemes helps you to know cost differences. 

Who Should Invest in Debt Funds?

Many investors prefer debt funds based on different financial requirements: 

• Investors seeking regular income
  Such investors may consider debt funds and use their systematic withdrawal plans. The fund earns returns in the form of interest income and potential capital gains. 
• Conservative investors
  Debt funds may be of interest to conservative investors who want to diversify beyond fixed deposits. Such funds are able to give a little better return than the usual saving plans, but with market risks. 
• For parking short-term surplus funds
  The liquid funds or ultra-short duration funds may serve as parking solutions to investors who have surplus funds with short-term liquidity. These alternatives offer liquidity daily and also some interest revenue. 
• For retirees looking for capital preservation
  Short term to medium term funds or banking and PSU funds might be attractive to retirees who want to preserve capital and earn a little income as well. This group is focused on credit quality and reduced volatility. 

Debt funds are not for investors who expect guaranteed returns or those who are not ready to accept fluctuations in NAV. Interest rate changes and credit events can cause temporary NAV decline. 

How to Invest in Debt Funds Online with HDFC SKY

Through the HDFC SKY platform, investment in debt mutual funds can be done through a digital platform. The process follows the following steps:

• KYC (Know Your Customer) formalities are required to register on the HDFC SKY platform. Investors are asked to provide ID, address proof and a PAN card. 
• Once registered, investors will be able to view the debt fund schemes offered on the site. The interface contains scheme details, historical performance, portfolio composition and risk indicators. 
• The selection of a particular debt fund enables the investors to move forward with the investment process. The platform accepts lump sum investments and SIP (systematic investment plans) investments in select schemes. 
• Payment methods include net banking, UPI and debit cards. The transaction is processed by the platform, and unit allotment at the relevant NAV is confirmed. 
• The dashboard provides investors with an opportunity to keep track of their investments, view the history of transactions, and review account statements. It is also easy to redeem and change schemes online at the platform. 
• HDFC SKY has research tools and fund comparison features to help in decision-making. Investors should review scheme documents and risk factors before committing to any investment. 

The Finance Act 2023 made some changes in the debt mutual fund taxation structure for debt mutual funds with effect from April 1, 2023. These debt fund taxation changes apply to investments made on or after this date.

Capital Gains Tax: In Debt funds, equity investment does not exceed 35% of the portfolio. For such funds, the gains are taxed as below 

Purchased before 1st April 2023	LTCG tax @ 12.5% (if holding for more than 2 years) STCG tax at applicable slab rates when computing income tax
Purchased after 1st April 2023	Tax at applicable slab rates when computing income tax (irrespective of holding period)

Benefits And Risks Of Investing In Debt Funds

Benefits:  

• Debt funds offer liquidity as compared to a bank fixed deposit. Most categories of debt funds provide for redemption on any business day with proceeds normally credited within one to three business days. 
• Professional fund management brings to the table expertise in security selection, credit analysis and interest rate assessment. Fund managers actively manage portfolios so as to navigate market conditions. 
• Diversification among multiple securities lowers the concentration risk. A single debt fund owns tens or hundreds of securities, so the risk is diversified across issuers and maturities. 
• Lower expense ratios than actively managed equity funds mean more money comes to the investors. Operational efficiency of scale benefits the investors of larger funds. 

Risks:

Interest rate risk is an issue for all debt funds. When interest rates increase, the value of existing bonds will decrease, leading to a decline in NAV. Also, these funds carry credit risk. It is a result of the potential default by issuers. Corporate bonds have levels of credit risk depending on the financial health of the issuer.  

Things To Consider Before Investing In Debt Funds

• Investment Objective Alignment
  Make sure the debt fund category is aligned with the purpose. Emergency funds need liquid funds, whereas medium-term goals can be suited to duration funds. 
•  Scheme Document Review
  The Scheme Information Document consists of details of investment strategy, risk factors, expense structure, exit load, etc. This document contains basic information that is essential for making informed decisions. 
•  Portfolio Quality Assessment
  Examine the credit rating profile of holdings on a monthly basis through factsheets. Higher allocation to AAA-rated securities suggests that there is lower credit risk. 
• Exit Load Structure
  There are funds that impose exit loads on redemptions made over certain time periods. This affects efficient gains on short terms.  
• Fund House Reputation
  The history of the asset management company in managing the debt fund puts the company into perspective. Market cycles Review performance in accordance with investment mandates. 
•  Macaulay Duration
  This is an interest rate sensitivity metric. Higher duration means larger NAV volatility to changes in interest rates.