How to Select the Correct Debt Fund

Debt funds in mutual funds are a type of mutual fund that invests in debt securities such as corporate bonds, money market instruments, commercial paper, certificate of deposit, treasury bills and government securities.

Types of Debt Funds in India

Dynamic Bond Funds
Dynamic bond funds are a type of debt fund that invest across duration and have different average maturity periods as these funds take investment decisions based on interest rates and invest in instruments of longer as well as shorter maturities.

Short Duration Funds
These type of debt funds make investments in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 1 year – 3 years.

Liquid Funds
Liquid funds are a type of debt funds that invest in debt instruments with a maturity of not more than 91 days. This makes them relatively less risky. They are better alternatives to savings bank accounts as they provide similar liquidity with higher returns.

Gilt Funds
These type of debt funds make minimum investment in Gsecs- 80% of total assets (across maturity). Gilt funds are perfect for risk-averse fixed-income investors.

Fixed Maturity Plans
These funds also make investments in fixed income securities like corporate bonds and government securities. All FMPs have a fixed period for which your money will be locked-in. However, one can invest only during the initial offer period thereafter can be purchased or sold through stock exchange platform.

From an investor’s point of view, debt funds in India are regarded as relatively less volatile than equity funds. However, there are different types of risks associated with debt funds.

The following factors should be considered before investing in debt funds.

Types of Risk in Debt Funds
Debt funds run the risk of credit risk and interest rate risk. In case of credit risk, the fund manager may invest in securities with a poor or risky credit rating with a high probability of default on payment. In case of interest rate risk, the bond prices may fall due to an increase in the interest rates.

Debt fund managers levy a certain fee to manage the money called an expense ratio.

Investment horizon
If you have a short-term investment period of three months to one year, then investing in liquid funds is ideal. The Macaulay duration of underlying investments for short-term bond funds can be one year to three years. In case of investment across duration, dynamic bond funds would be appropriate. The longer the time plan, the better the returns.

Investment objective
Depending on your financial goals, different types of debt funds could serve your purpose. Investors can park a certain amount of funds in debt funds for liquidity.

Tax implications
Capital gains – both long term and short term from debt funds are taxable under the Income Tax Act 1961.