Bring stability to your investment portfolio with Debt Mutual Funds

In this article you will learn about

• Role of debt funds in your portfolio
• How to invest in debt funds
• Selecting debt funds to suit your financial goals

Mutual funds are not just about equities that provide growth; it is also about bringing stability to your investment portfolio with investments in debt funds. A debt fund is a mutual fund scheme that invests in fixed income instruments, such as bonds, corporate debt securities and money market instruments, which are less volatile compared to equities. Investments in debt funds are suitable for short- to mid-term goals and for investors who want regular income and are risk-averse. Debt funds are also reasonably safe and liquid with the potential to earn higher returns compared to traditional debt avenues like band deposits.

The debt fund category can be categorised based on their indicative investment horizon and investment strategy. You could select a debt fund based on the time horizon, liquidity needs and your risk appetite. You can understand the functioning of debt funds as they are based on two strategies to derive returns – accruals and duration, which is nothing but capital appreciation. The accrual strategy depends on interest income to generate returns by managing credit risk to earn higher yield while minimizing interest rate risk. In funds that follow this approach, the securities that it holds are generally held till maturity, which is the case for mostly funds that have a shorter maturity.

A fund following a duration strategy seeks to gain from bond price rallies when interest rates fall. So, when interest rates fall, bond prices rise – since new bonds will carry a lower interest, existing bonds become more attractive and thus prices rise until yields match the new bonds. A duration fund will try to make capital appreciation from the bonds it holds. The aim of these funds is to generate returns by actively managing interest rate risk by investing in long-term debt instruments. Longer duration and gilt funds follow this approach.

According to the Securities Exchange Board of India (Sebi), there are 16 defined categories of debt funds. These funds can be classified based on their indicative investment horizon and investment strategy. Investors can choose a debt fund based on the time horizon, liquidity needs and their risk appetite.

An important factor in the performance of debt funds is prevailing interest rates. For instance, an accrual fund does not try to time the interest rate cycle. Given the rate scenario and its own mandate, it will look for those instruments that deliver an optimal yield. However, a duration fund will estimate the direction interest rates will move and adapt the portfolio to maximise the chances of bond price appreciation. So, when rates are falling, duration typically delivers more than accrual. And, when interest rates are rising, a duration strategy will not work as bond prices will fall. In these times, an accrual fund with higher yields will deliver more.

Yet another aspect to know when investing in debt funds is capital gains tax. Long-term capital gains on debt fund are taxable at the rate of 20% after indexation. Indexation is a technique that involves factoring the rise in inflation from the time of purchase to sale of the units. Indexation allows inflating the purchase price of debt funds to bring down the quantum of capital gains. You are required to add short-term gains from debt funds to your overall income. They are subject to short-term capital gains tax (SCGT) as per the income tax slab you fall under.

Next steps

• List your financial goals with time frames
• Select suitable debt funds based to meet the goals
• Match funds that suit your investment objective and risk profile