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Note From Kalen: I’m not an expert in debt funds, but I think they can be a great way to diversify your portfolio. Today I have Tanu Shree Jain, from Elearnmarkets, explaining debt funds and why they’re one of the best kept secrets of mutual funds. Enjoy!

Debt funds are mutual funds that invest in fixed income securities issued by the government and private companies.

Some prominent examples of debt funds can be monthly income plans (MIPs), liquid funds, corporate bonds etc.

There can be other options as well that an investor can think of investing his/her money. For e.g. a debt mutual fund may comprise of a debt component like Treasury bills, Government Securities and any other fixed income security of a different time horizon.

Safe or Risk-Free?

Debt funds are relatively safer than equity because in equity market, the fluctuations are more.

However, debt funds carry with them various types of risks such as credit risk (risk of losing capital or interest) and interest rate risk (risk of change in interest rates).

Hence, investors should choose a portfolio that is proportionately apportioned between debt and equity so that he/she can spread his/her risk-reward ratio.

Who should choose debt funds?

Investors who have a relatively lower low risk taking capacity and looking for stable returns should look for funds that match their risk-return horizon.

Select the fund that is best suitable to you

Determination of time for which the investor can lock his money is an important task in this. There are different types of schemes available for different time horizons. An investor can invest in the scheme most suitable for him/her according to his/her time frame. If the investor wants to invest for a short period, say few days or few weeks, he/she can do so by investing in either liquid scheme or ultra-short term scheme. For long term, he can opt for long term schemes. So basically, there are all types of schemes for all types of investors and all types of time frames.

Tax Free?

There are two types of taxes charged on the debt fund- short term capital gain tax and long term capital gain tax. An investor who holds his investment in debt fund for less than 3 years falls in the short term capital gain tax and will be charged as per the normal tax slab applicable to him. But, if the investment in debt fund is held for more than 3 years, it will fall under long term capital gain tax and tax rate in this case will be 20% along with indexation plus 3% cess. So that totals to 20.9%

Short term debt funds

Short term debt funds are those funds that invest in debt securities that have a short maturity period, say one to three years. The investors pool their money for a short period of time in instruments like commercial paper, treasury bills, certificate of deposits etc.

Long term debt funds

Long term debt funds are those funds that invest in debt securities for a long period of time, say more than 3 years. These funds are suitable for investors who can hold their money for a long period of time and investors should select the fund after matching its risk-return horizon with their own.

Debt-oriented hybrid funds

The funds that invest 75-90% of the money in debt funds and the remaining portion in equity funds are called debt oriented hybrid funds.

Debt Fund Vs. Fixed Deposit

For investors who want a secured type of investment with minimal or no chance of default, fixed deposits are the most preferred type of investment. Unlike bank deposits, debt funds are not fully secured. Investors are affected by both credit risk and interest risk.

Taxation

There are two types of taxes charged on the debt fund-

  • Short term capital gain tax and
  • Long term capital gain tax.

According to Bank Bazaar, an investor who holds his investment in debt fund for less than 3 years falls in the short term capital gain tax and will be charged as per the normal tax slab applicable to him. But, if the investment in debt fund is held for more than 3 years, it will fall under long term capital gain tax and tax rate in this case will be 20% along with indexation plus 3% cess. So that totals to 20.9%.

Liquidity

When we talk about liquidity, there is not much difference between the debt fund and the fixed deposits because both have the same liquidity period. However, in case of fixed deposits, if the money is withdrawn before the maturity period, some amount of penalty can be imposed. Also, in case of debt funds there is an exit load that is usually paid on redemption.

Returns

Since debt funds are subject to many types of risks, i.e. credit risk and interest rate risk, returns in debt funds are generally higher in debt funds than bank deposits.

Debt Mutual Funds vs. Equity Mutual Funds

Debt mutual funds are those funds that invest in a mix of debt with fixed income and other debt securities but major portion of the investment is in fixed income debt securities.

Whereas equity mutual funds are those funds that invest major portion of investment in money market securities, i.e. equity or cash market.

Risk

Equity mutual funds carry much higher risk than debt funds. Debt funds are funds that receive a fixed income however equity funds do not receive a fixed income instead they are subjected to an inherent risk which is much higher than the risk element in debt funds.

Returns

As the saying goes, higher risk, higher returns. Since equity mutual funds are riskier than debt funds, they also receive higher returns than the debt mutual funds. They may receive negative returns also sometimes.

Recurring Deposits vs. Debt Funds

For investors who are looking for secured returns, they should look for an investment in recurring deposits as they give fixed assured returns. Investors who can bear a little risk can go for short term debt schemes as the returns are higher than the recurring deposits.

Arbitrage Funds Vs. Debt Funds

Arbitrage funds are a type of mutual fund that bridges the difference between the price in the cash market and the derivatives market in order to generate returns. Basically what happens is you simultaneously buy and sell same securities in two different, for example, buying in the cash market and selling futures of the same stock in the derivatives market.

The returns of arbitrage funds are tax-free if you hold them for one year. Liquid and short-term debt funds, on the other hand attract a tax rate of around 36% if the investor tends to fall in the highest tax bracket.

Arbitrage Funds are categorized as equity oriented schemes; hence, gains on units held for over a year are subjected to equity mutual fund taxation.

Thus, arbitrage schemes provide low-risk and short-term investors a huge tax advantage.

Debt Funds Vs. Gilt Funds

Funds that invest in securities that have a maturity period of medium to long term are called gilt funds. These funds are issued by the Government. These funds have very less probability of default. On the other hand, debt funds are a little riskier than gilt funds. The value of gilt funds change depending on the interest rates and various other economic conditions.

Unlike debt funds, interest rate risk in gilt funds is highly dependent on the maturity profile. Higher the time for maturity, higher is the interest rate risk.

Debt Funds Vs. Balanced Funds

Balanced Funds are those funds that generate high returns with moderate risk profile. Investors who have medium level of risk appetite can invest in these types of debt funds. These are a type of hybrid funds with major part invested in equities and rest in some fixed income securities whereas in case of debt funds, it is vice versa.

About the Author:
Tanu Shree Jain is a Knowledge Associate at Elearnmarkets.com. A commerce graduate from Delhi University. She strongly believes in the following saying by Warren Buffett- “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it”

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