When investing in a mutual fund, one has to think about the investment horizon, the risk they can take and for how long they can remain invested. Broadly there are equity and debt funds. In this article we will help you understand what investment in a debt fund will entail.
What is Debt Fund?
A debt fund is a type of mutual fund which predominantly invests in fixed-income securities such as government securities, corporate bonds, certificate of deposit and other money market instruments.
Who Should Invest in Debt Funds?
Debt funds are a suitable investment option for conservative investors who do not want to undertake much risk and are comfortable with earning returns which are although high but lower than equity funds. Debt funds are suitable for all investment horizons, be it as short as 1 day, 1-3 months or as long as 15 years.
How Do Debt Funds Generate Returns?
Debt funds generate returns in the following 2 ways:
- Interest Income: The fixed income securities/bonds which they hold feature a predetermined interest rate termed as the coupon rate and provide them with an interest amount at periodic intervals.
- Portfolio Valuation Change: Debt funds generate returns by change in value of their individual holdings. The value of their bonds and other fixed income holdings changes due to economy-wide interest rate and credit rating movements.
Top 5 Debt Funds
|Fund Name||1 Year Return||3 Year Return||5 Year Return|
|Reliance Gilt Securities Fund||18.45%||10.13%||12.20%|
|Franklin India Dynamic Accrual Fund||9.79%||9.29%||10.42%|
|SBI Magnum Medium Duration Fund||11.64%||9.55%||10.18%|
|ICICI Prudential All Seasons Bond Fund||11.23%||8.58%||10.72%|
|Axis Dynamic Bond Fund|
1. Reliance Gilt Securities Fund
Average Maturity: 8.40 years
Modified Duration: 5.67 years
Yield to Maturity (YTM): 8.07%
Reliance Gilt Securities Fund is a more than a decade old fund which was launched in 2008. The scheme has outperformed its benchmark during all the above-mentioned 3 periods – 1 year, 3 year and 5 year. Since the scheme all its assets in government securities, it features 100% credit risk-free.
2. Franklin India Dynamic Accrual Fund
Average Maturity: 2.89 years
Modified Duration: 2.12 years
Yield to Maturity (YTM): 11.33%
Franklin India Dynamic Accrual Fund made its debut in March 1997. It is a well performing fund which has given returns better than its benchmark during both short and long term periods. The scheme has invested a majority of its assets in corporate debt instruments and thus features a moderate risk quotient.
3. SBI Magnum Medium Duration Fund
Average Maturity: 2.90 years
Modified Duration: 4.06 years
Yield to Maturity (YTM): 9.13%
SBI Magnum Medium Duration Fund is a good Medium Duration debt scheme which was launched in November 2003. The scheme has outperformed in both the long-term periods of 3 years and 5 years. The scheme has invested around 40% of its assets in AAA rated debt instruments, one of the safest debt instruments and hold another 8% in sovereign debt securities.
4. ICICI Prudential All Seasons Bond Fund
Average Maturity: 4.74 years
Modified Duration: 3.02 years
Yield to Maturity (YTM): 8.68%
ICICI Prudential All Seasons Bond Fund is a time-tested fund which was launched 17 years ago in March 2002. The scheme is a good pick for long-term investment horizons wherein it has succeeded in outperforming its benchmark. The scheme features a strong portfolio, holding 17% of its assets in government securities and another 73% in AAA/AA rated debt instruments.
5. Axis Dynamic Bond Fund
Average Maturity: 6.80 years
Modified Duration: 4.70 years
Yield to Maturity (YTM): 8.64%
Axis Dynamic Bond Fund is an established fund which was launched in April 2011. The scheme features an impressive track record wherein it has given returns better than its benchmark during 1 year and 3 year periods. The scheme has nearly mirrored its benchmark performance during the previous 5 year period. The scheme has invested a majority of its assets in sovereign securities which help it to feature a moderate risk quotient.
Tax Treatment of Debt Funds
A mutual fund provides returns in 2 forms – Dividends and Capital Gains and both are taxed differently. The tax on dividends known as a dividend distribution tax (DDT) is paid by the fund house to the government on behalf of the investors by deducting the same from his/her return earnings. Thus, an investor is not required to pay any tax on received dividends.
The capital gains earned on mutual funds attract a Capital Gains Tax and that is taxable at the hands of the investor. The capital gains tax treatment of debt funds is as follows:
|Nature of Tax||Holding Period||Tax Rate|
|Short Term Capital Gains Tax||Up to 36 months||Income Tax Slab Rate of Investor|
|Long Term Capital Gains Tax||More than 36 months||20% after indexation|
Types of Debt Funds
There are 13 types of debt funds to suit different time horizons and portfolio preferences of investors.
- Overnight Fund: It invests in overnight securities having a maturity of 1 day. Due to the short maturity period, overnight funds carry very little interest rate fluctuation risk and credit default risk and are therefore an extremely safe investment option.
- Liquid Fund: They invest in debt and money market securities with a maturity of up to 91 days. Investors who wish to park their idle money for a short period of time, bearing the least amount of risk, should go for liquid funds. Liquid funds generally give returns higher than savings accounts but similar to fixed deposits.
- Ultra Short Duration Fund: These funds invest in debt and money market instruments such that the Macaulay Duration of the fund is between 3 to 6 months. These funds generally offer returns higher than bank fixed deposits and involve a relatively low amount of interest rate risk.
- Low Duration Fund: They invest in debt and money market instruments such that the Macaulay Duration of the fund is between 6 to 12 months.
These funds feature a low interest risk quotient and offer moderate returns.
- Money Market Fund: It invests in money market instruments having a maturity of up to 1 year. This fund provides investors with liquidity and relatively low risk of principal by investing in relatively low-risk short-term securities.
- Short Duration Fund: These funds invest in debt and money market instruments such that the Macaulay Duration of the fund is between 1 to 3 years. Considering the maturity period, these funds provide relatively low returns but also carry low amount of risk.
- Medium Duration Fund: They invest in debt and money market instruments such that the Macaulay Duration of the fund is between 3 years and 4 years.
- Medium to Long Duration Fund: An open-ended debt scheme which invests in debt and money market instruments such that the Macaulay Duration of the fund is between 4-7 years.
- Long Duration Fund: It invests in debt and money market instruments such that the Macaulay Duration of the fund is more than 7 years.
- Dynamic Bond Fund: These funds invest in debt schemes of dynamic nature (in terms of their composition) and of varying tenures. They are ideal for investors with 3-5 years time horizon and moderate risk appetite.
- Corporate Bond Fund: They invest at least 80% of its total assets in highest-rated corporate bonds. These funds are capable of providing high returns and also carry a low amount of risk by investing in high-rated instruments.
- Credit Risk Fund: It invests at least 65% of its total assets in corporate bonds with credit rating below the highest rated corporate bonds. These funds are typically capable of generating 2-3% higher returns compared to risk-free instruments and carry a higher level of risk.
- Banking and PSU Fund: These schemes invest a minimum of 80% of its total assets in debt instruments of banks, public sector undertakings (PSUs), and public financial institutions and are therefore quite safe.
- Gilt Fund: These funds invest at least 80% of its total assets in government securities across maturities and thus carry no credit risk. However, these funds do feature a high level of interest rate risk.
- Gilt Fund with 10 year constant duration: These funds invest a majority of their total assets in government securities such that the Macaulay Duration of the fund is 10 years.
- Floater Fund: It invests at least 65% of its total assets in floating rate instruments. This type of fund has a low level of interest rate risk because the instruments it holds have their rates periodically reset to prevailing interest rates.
List of Best Performing Debt Mutual Fund Schemes with Returns
What Are The Risks In Debt Funds?
There are 3 factors principally that affect the returns on debt funds – credit risk, interest rate risk, and liquidity risk.
Credit Risk: Credit risk refers to the risk of default of repayment on the bonds/securities held by the fund. This risk is typically assessed and rated by ratings agencies (for instance by assigning ratings like AAA, AA etc). If the chances of default in a particular bond increases, the ratings agencies downgrade the concerned bond, causing a decrease in the value of the debt fund holding it.
Interest Rate Risk: Interest risk refers to the risk of change in the value of the fund’s bonds/securities due to a change in the interest rates. In the event of an increase in the interest rate, the value of the debt fund falls and in case of a decrease in the interest rate, the value of the debt fund rises.
The exact percentage by which a debt fund’s value will rise or fall is given by an indicator called ‘Modified Duration’. For instance a modified duration of 3 means that a 1% rise in interest rates in the economy, will cause a drop in the value of concerned debt fund by 3%.
Liquidity Risk: Liquidity risk refers to the risk of the fund manager being unable to honour redemptions due to illiquidity in the debt securities held by the fund.