Based on the ‘investment objective’, the mutual fund schemes can be broadly classified as either Equity Funds or Debt Funds. This classification is based on the asset allocation of the fund’s investments.
Equity Funds invest in Stocks / Shares. Equity Mutual Funds typically ensure that they invest at least 65% in equities and the rest in fixed income securities.
In case of Debt mutual funds, they invest in various fixed income instruments like bank Certificates of Deposits (CDs), Commercial Papers (CPs), treasury bills, government bonds (G-secs), PSU bonds and corporate bonds/debentures, Company Fixed Deposits, cash and call instruments, and so on..
Most of the Debt funds do not invest in Equities or shares. This is again dependent on the fund’s investment objective. Some Debt funds do invest in equities and hence these are called as ‘Hybrid Debt Funds’ or ‘Blended Debt Funds’.
In this post, let us understand – What are different types of Debt Mutual Funds? Where do Debt funds invest? Are Debt funds suitable for short term & long term financial goals? What are the advantages or benefits of investing in Debt funds? Debt Funds Vs Bank Fixed Deposits.
Types of Debt Funds
Equity funds invest in shares and these investments can be held as long as possible (based on the fund’s strategy). Debt funds invest in fixed income securities like bonds, deposits etc., and these investments have fixed tenure (varying time-frames). The primary aim of a debt fund is to generate steady returns by investing in ‘interest’ paying securities.
So, there are various types of Debt Mutual Funds that invest in various fixed income securities of different time horizons. (Time-horizon is from Fund’s view-point and not from an investor’s point of view.)
- Liquid Funds / Money Market Funds
- Where do these funds invest? – These funds invest in highly liquid money market instruments that provide easy liquidity. The period of investment in these funds could be as short as a day. (There are several money market instruments, including treasury bills, commercial paper, bankers’ acceptances, deposits, certificates of deposit, bills of exchange etc)
- What are the Expected Returns? – Investment Returns from Liquid funds can be slightly better than Savings Bank Account. Returns on these funds tend to fluctuate less when compared with other debt funds.
- Who should invest in Liquid funds? – If you want to park your surplus cash for very short-periods say 1 to 3 months, opt for these funds. Do not invest in Liquid Funds for a longer period as these offer low single-digit returns at best.
- Examples : Axis Liquid Fund & HDFC Liquid Fund etc.,
- Ultra Short-Term Funds
- Where do these funds invest? – These funds are also known as Liquid plus funds or Cash / Treasury Management Funds. They generally invest in very short term debt securities with a small portion in longer term debt securities. (Funds investing in slightly longer duration debt securities than Ultra short term funds are referred to as Short term funds)
- Returns – These funds can generate better returns than Liquid Funds. Suitable for investors who are willing to marginally increase their risk.
- When to invest in Ultra Short-term funds? – If you have surplus money which needs to be invested for say 3 to 9 months, you can consider investing in these funds.
- Examples: Axis Banking Debt Fund, IDFC Banking Debt Fund,Birla Sunlife Short-term fund etc.,
- Income Funds
- Where do these funds invest? – They invest a major portion in various debt instruments such as bonds, corporate debentures, government securities and money market instruments of various maturities and issuers. These funds can further be classified as, Gilt Funds, Long-term Income Funds and Dynamic Bond Funds. Gilt Funds invest in government securities of medium and long term maturities issued by central and state governments. Dynamic Bond Funds invest in debt securities of different maturity profiles. These funds are actively managed and the portfolio varies dynamically according to the interest rate view of the fund managers.
- Returns – You can expect better returns on these funds when compared with Short term or Liquid funds. But you should be ready to take higher risk. These funds generally tend to give better returns when the interest rates have peaked and when the interest rate cycle is in downward trend. Most of the gilt funds or income funds have given double digit returns over the last 1 to 2 years.
- Who can invest? – These funds are suitable for investors who are willing to take a relatively higher risk and have longer investment horizon (say 1 to 3 years). You can consider Gilt funds in a falling interest rate scenario. Invest in a Dynamic Income fund if you want to gain from both rising and falling interest rate scenarios. But, dynamic funds can have high interest rate risk associated with it.
- Examples : L&T Gilt Fund, SBI Magnum Gilt, HDFC High Interest Dynamic Fund, IDFC Dynamic Bond Fund, TATA Dynamic Bond Fund etc.,
- Monthly Income Plans (or) Hybrid Debt Funds
- Where do these funds invest? – These funds invest in a mix of Debt and Equity in the proportions of say 80:20 or 70:30 or other proportions of similar kind. The objective of these funds is to provide enhanced regular returns to risk-averse investors by taking small positions in equity assets. The debt portion ensures stability, safety and consistency, while the equity instruments in the portfolio boost the returns. Kindly note that MIPs are market-linked products (to the extent of their equity portfolio).
- Returns – Good MIPs can give you better returns than bank fixed deposits. Infact, some of the MIPs sometimes do give double digit growth depending on the interest rate cycle.
- Who can invest? – If you have a financial goal which is 2 to 3 years away from now, you can surely consider investing in MIPs instead of investing in bank FDs or RDs.
- Examples : Kindly read ‘Best Mutual Fund Monthly Income Plans‘.
Below are some of the other forms of Hybrid Debt funds.
- Capital Protection Funds: Capital Protection Funds (CPFs) are close-ended schemes. These funds invest in debt instruments in such a way that at the end of the term (tenure) of CPFs, the value of debt investment is equal to the original investment in the fund. The equity portion aims to add to the returns of CPFs at maturity. Do note that these funds are oriented towards protection of capital and do not offer guaranteed returns. These funds are rated by Credit Rating Agencies like CRISIL / ICRA.
- Fixed Maturity Plans : These are also close-ended schemes and are similar to CPFs. These funds have fixed tenure like 400 days, 1000 days etc., Units of these close-ended funds can be purchased only during the New Fund Offer period and cannot be redeemed during the tenure of such funds. To provide liquidity to investors, FMPs are also listed on Stock Exchanges. If you are looking to park your money for a fixed tenure during uncertain interest rate movements, FMP is the answer.
Risk Vs Return of various Debt Funds
As discussed above, the longer the maturity of the fixed income securities, the higher the interest rates risk. Accordingly, risk-reward relationship can be represented as below;
Debt Funds & Tax Implications
From taxation point of view, MF schemes that invest at least 65% of its fund corpus into equity and equity related instruments are treated as Equity Funds.
Mutual Fund Schemes that hold less than 65% of their portfolio in equities and equity related instruments are treated as Debt Fund (Non-Equity Funds).
- Long Term Capital Gains (LTCG) – If you make a gain / profit on your investment in a Non-Equity Mutual Fund scheme (or in a Debt Fund) that you have held for over 3 years, it will be classified as Long Term Capital Gain. The LTCG tax rate on Debt Funds is 20% (with indexation benefit).
- Short Term Capital Gains (STCG) – If you make a gain / profit on your Debt fund (or other than equity oriented schemes) that you have held for less than 36 months (3 years), it will be treated as Short Term Capital Gain. The gains are taxed as per your Income Tax Slab rate. (You may like reading – “Mutual Funds & Tax implications“)
My Opinion (Debt Mutual Funds Vs Bank Fixed Deposits)
Debt Mutual Funds offer several benefits. But most of the small investors know little about them and prefer to invest in Fixed Deposits or Recurring Deposits. So, let’s compare debt mutual funds with bank deposits.
- TDS is applicable on Bank FDs/RDs, if your interest income exceeds Rs 10,000 a year. The other issue is that the interest income is taxed on annual basis. TDS is not applicable on Debt fund redemptions. Also, the tax is deferred indefinitely till you redeem your Debt fund units.
- One more advantage with debt funds is that the gains from a Debt Fund can be set off against Short-term & Long-term capital losses (if any) from your other investments.
- If you have lump sum money to be invested in Equity oriented Fund, you can opt for STP (Systematic Transfer Plan) from a Liquid Debt fund to an Equity fund of your choice (within same AMC).
- Debt Funds can give better returns than your Savings Bank Account & Bank deposits.
- Safety of capital is almost the same with both the options (Debt MFs & FDs). FDs may offer you assured returns but Debt funds can offer you higher post-tax returns. (You may like reading – ‘Why you should avoid investing in Bank FDs/RDs for longer periods)
- If you are in 20-30 per cent tax bracket, tax-efficient debt funds can be more beneficial to you than FDs.
- Investors generally compare debt funds’ past returns with FD or Bank interest rates. But, Debt Fund returns should be compared to FD rates that were prevailing at the start of the period of comparison.
- Debt Funds can also be considered for investment during your Retirement phase for Systematic Withdrawals.
- Debt Funds are as liquid as your Bank deposits. However, some funds can levy Exit Load for exiting before the minimum holding period. Even a 0.5% to 1% exit load can shave off a significant portion from your gains. So, have an eye on exit load.
If you have any financial goal(s) which is less than 5 years away, which can be met with 8% to 10% rate of return (or) when you are not comfortable with high volatility (risk) then you can surely consider investing in Debt Funds.
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