From Investment Instruments, Returns To Maturity—All You Need To Know About Debt Mutual Fund

A debt mutual fund invests money in debt-based instruments like government bonds, sovereign bonds, and fixed-income securities. Debt funds could be valuable to your portfolio during a recession or a volatile market situation as these assets are considered less volatile than equity.

Thus, a debt mutual fund provides stability to the portfolio during a volatile market as the government bonds, and debt securities have lower risks with stable returns compared to the equity market.

Types of Debt Fund

Overnight Fund

An overnight fund invests your money in Treasury bills, which are government-backed debt bonds that typically expire in a day and pay a nominal interest rate. The returns are not huge, but there is a safety net of minimal risk because these bonds have high credit ratings. In addition, the risk is minimal because these bonds are issued by the government, which is less likely to default on these bonds.

Money Market Fund

Money market funds invest in short-term debt instruments such as treasury bills, certificates of deposit, commercial paper, and government securities. Because the maturity time of these debt instruments is short and they keep a sizable portion of assets under management liquid, the fund's liquidity is strong, which means you can redeem your investment rapidly compared to an equity fund. It is also one of the safest investment funds because it exclusively invests in debt instruments with high ratings.

Liquid Fund

These funds invest in corporate and government debt bonds with maturity periods of up to 91 days. These instruments include certificates of deposit, commercial paper, and treasury bills. They could be an ideal investment vehicle if you want nominal returns with minimum risk, as their ratings are high.

Ultra-Short Duration Fund

These mutual funds choose bonds and debt investments so that the portfolio's average maturity period is around three and six months. Although they may offer lower returns, funds with shorter duration are less susceptible to changes in interest rates.
Investors looking for alternatives to bank accounts or deposits and want to make relatively short-term investments can invest in Ultra-short duration funds.

Low Duration Fund

Low-duration funds are debt funds that invest in short-term debt instruments with maturity periods ranging from 6 to 12 months. Low-duration funds must keep their fund duration between 6 to 12 months, as per SEBI rules. This means that low-duration funds will most likely only invest in short-term debt securities. As a result, low-duration funds can protect you from interest rate risk. In addition, these funds increase their interest profits by investing their assets in instruments with credit ratings of AA or lower, which pay higher interest rates with low risk.

Short Duration Fund

These funds invest in debt instruments and money market securities. The maturity period of these securities is between 1 and 3 years, and they invest in instruments like debenture, Government of India Securities, certificate of deposit, floating rate bonds, and non-convertible debenture. Hence, the exposure to interest rate risks is high. However, it also provides higher returns than debt funds, which invest in shorter maturity instruments.

Medium Duration Funds

If a fund invests in a debt instrument with a maturity period of between 3 and 4 years, it is called a medium-duration fund. As the maturity period of a fund increases, the risk associated with it also increases, as the debt bond issuer might default on its loan, but the interest rates on these bonds are much higher, thus generating higher returns. The investor can also benefit from long-term capital gain tax and indexation benefits if the fund is redeemed after three years. However, the liquidity of this fund is low, so it might take around three days to redeem your investment.

Corporate Bond Funds

Corporate Bond funds are debt mutual funds that invest at least 80 per cent of their assets in corporate bonds, which have high ratings, thus providing a high level of safety. In addition, they invest in instruments like debenture, non-convertible debenture, and government securities, which have high credit ratings and provide high liquidity. These funds also keep liquid assets, so the redemption period is less.

Credit Risk Funds

These funds invest in instruments with low credit ratings, meaning their probability of default is high, but they also pay high interest. For example, credit risk funds invest 65 per cent of their assets in debt bonds with low credit ratings. So, the key factor here is finding a fund that has balanced investments between instruments with low credit-high return bonds and high rating bonds. 

Banking and PSU Debt Fund

Banking and PSU debt mutual fund schemes invest in debt instruments issued by banks, PSUs, and public financial organisations (PFI). According to SEBI's mutual fund classification standards, banking and PSU funds must invest at least 80 per cent of their assets in securities issued by such institutions. These funds are thought to have higher credit quality than other debt fund types. If the interest rates go up, these mutual funds can provide higher returns as they have provided debt to banking institutions which will benefit from the high-interest rates.

Gilt Fund

A Gilt fund must invest at least 80 per cent of its net assets in government securities. The gilt fund focuses on government securities, and the risk of the government defaulting on these bonds is low, so the risks in such funds are also low. However, investors may be subject to interest rate fluctuations depending on the fund's term.

Dynamic Debt Fund

Dynamic Bond Funds are debt mutual funds that invest in debt and money market instruments of varying durations, such as government securities, corporate bonds, etc. These funds have no restrictions on the duration or maturity of the securities they invest in. These funds are designed so that fund managers can generate higher returns by taking advantage of changes in interest rates in the economy. This is accomplished by increasing or decreasing the lending duration based on whether interest rates are rising or falling.

Tax Benefits

The tax rate is determined by the holding time of the investors. Investors holding debt mutual funds for more than three years are eligible for long-term capital gains. Twenty per cent tax is levied along with indexation benefit, which is the factor that considers inflation and reduces the tax according to Cost Inflation Index (CII), calculated for each year. On the other hand, if investors invest for less than three years, the profits are added to their income and taxed according to their tax bracket.

Risks Involved

Debt mutual funds invest in debt instruments, which means they invest in bonds, which loan out money. International and national agencies like CRISIL and CARE rate these bonds, so it is always better to check which debt fund is investing in high-rated debt bonds.