Understanding debt mutual funds

Shaily Shah
September 30, 2021
800 Mins
Understanding debt mutual funds

When companies want to raise funds, they borrow money by issuing debt instruments. In return, they deliver steady and regular returns. This is how a debt product works.

Debt mutual funds invest in fixed-income securities such as treasury bills, corporate bonds, commercial papers, government securities, and various other money market instruments. The return on these securities is usually not impacted by market movements so they provide stable returns than equities and are considered less risky. They are a great option for risk-averse investors. They provide steady returns and capital appreciation with lower risk. Debt fund has a pre-decided maturity date and a fixed interest rate which the investor can earn on maturity.

Features of Debt Mutual Funds-

1. Capital Protection

Debt mutual funds hardly provide any capital protection. This is because the underlying securities are vulnerable to market movements and so they are exposed to capital erosion.

2. Key Risks Associated with Debt Mutual Funds are:

Interest Rate Risk

There is a risk of RBI changing the interest rate due to which the underlying security gets impacted. To mitigate this risk, short-term investments can be preferred.

Credit Risk

This risk arises when there is a default in the interest or principal repayment by underlying securities issuers. This risk can be mitigated by investing in debt funds that have a high credit rating. This can reduce the risk of default.

3. Cost of Investment

Debt funds charge various kinds of fees such as sales and agent commissions, advisory and management, marketing and selling, audit and legal and many more which are charged to the investors through Total Expense Ratio (TER). Total expenses of the funds are divided by total assets held by the fund to give the expense ratio. To avoid paying high fees, direct mutual funds should be chosen for investment as these funds have a lower expense ratio than regular mutual funds. Download tarrakki app to start investing in direct mutual funds.

4. Returns

Returns that are generated by the debt funds rely on the interest income earned and capital gains garnered from the underlying securities. The credit rating agencies such as CRISIL, ICRA, CARE, that give ratings to the debt funds also build a base in deciding the interest income. The higher the rating of the security, the lesser the risk involved vis-a-vis the lower the rating, the higher is the risk involved. Therefore, interest rate and credit ratings are important aspects to look at before choosing a debt mutual fund.

5. Taxation

The returns that are garnered by investing for 3 years or less than 3 years are short-term capital gains. These gains get added to your annual income and are taxed according to your tax slab. The returns which are booked on redeeming your investments after 3 years are considered as long-term capital gains and are taxed at 20% with indexation benefits.

6. Premature Withdrawal

Under the categories of debt mutual funds, only the Fixed Maturity Plan (FMP) does not allow premature withdrawal but apart from that, all the other categories allow withdrawal by paying a minimum exit load if the funds are withdrawn before a predetermined period. There are few categories of funds that currently do not levy any exit load such as ultra-short term debt funds, liquid funds and most short-term debt funds. These options are a great idea when one needs higher liquidity and also for short-term investments.

Debt funds are open to all classes of investors – for those who have a low-risk appetite and even for those who have high-risk appetites. Debt funds are market-linked investments and there are no guarantees in terms of returns. Other factors to look at while investing in debt funds are past performance, expense ratio, AUM and others factors.

Companies can park their surplus funds in debt mutual funds and earn returns. Tarrakki provides investment module catering to MSMEs and corporates for companies to launch investment products for their end users for better treasury management. 

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