A debt mutual fund (also known as a fixed-income fund) invests a significant portion of your money in fixed-income securities like government securities, debentures, corporate bonds and other money-market instruments. By investing money in such avenues, debt mutual funds lower the risk factor considerably for investors. This is a relatively stable investment avenue that could help to generate wealth

Benefits of investing in debt funds

Stable income

Debt Funds have potential to offer capital appreciation over a period of time  While debt funds come with a lower degree of risk than equity funds, the returns are not guaranteed and subject to market risks.

Tax efficiency

Many people invest money for the prime reason of reducing their annual tax outgo. So, if tax reduction is a crucial investment goal, you can consider investing in debt mutual funds. This is because debt funds are more tax-efficient than traditional investment options like fixed deposits (FDs).

In FDs, the interest you earn on your investments is taxed each year based on the income slab for which you are eligible irrespective of the maturity date being in that year or later. In case of debt funds, you pay tax only in the year you redeem and not before that. You also pay tax only on the redemption proceeds, even if is a partial redemption. You pay Short Term Capital Gains (STCG) tax if you hold your mutual fund units for less than three years and Long-Term Capital Gains (LTCG) for investments beyond three years. LTCG are eligible for indexation benefits wherein you are taxed only on the returns which are over and above the inflation rate(embedded in cost inflation index {CII}). This helps to reduce your tax outgo as well as provides better post tax returns.

High liquidity

Fixed deposits come with a specified lock-in period. If you liquidate your FD prematurely, the lender may charge you a penalty. While debt mutual funds have no lock-in periods, some of the funds carry an exit load which is a charge deducted at source for early withdrawals. The exit load period varies from fund to fund while some funds have nil exit load as well. However, debt mutual funds are liquid and you can withdraw your money from the fund on any business day.

Stability

Investing in debt funds can also increase the balance of your portfolio. Equity funds (while offering higher return potential) can be volatile. This is because the returns on equity funds are linked directly to the performance of the stock market. By investing in debt funds, you can adequately diversify your portfolio and bring down overall risk (cushion the downside)

Flexibility

Debt mutual funds also offer you the option of moving around your money to different funds. This is possible through a Systematic Transfer Plan (STP). Here, you have the option to invest a lump sum amount in debt funds and systematically transfer a small portion of the fund into equity at regular intervals. This way you can spread out the risk of equities over a specified period of a few months rather than investing the entire amount at one point. Other traditional investment options do not offer this degree of flexibility to investors.

How do debt funds work?

Debt funds aim to generate returns for investors by investing their money in avenues like bonds and other fixed-income securities. This means that these funds buy the bonds and earn interest income on the money. The yields that mutual fund investors receive is based on this.

This is similar to how a Fixed Deposit (FD) works. When deposit in your bank, you are technically lending money to the bank. In return, the bank offers interest income on the money lent.

However, there are many more nuances to debt fund investments. For example, a particular debt fund can buy only specific securities of specific maturity ranges - a gilt fund can buy only government bonds while a liquid fund can buy securities of maturity upto 91 days. Debt funds also do not offer assured returns but have market linked returns which can fluctuate. Rising interest rates can have a positive impact on yields / interest income but a negative impact on bond prices. The reverse is true when interest rates fall.

What are different types of debt funds?

1. Liquid funds
   As the name suggests, liquid funds are a type of debt mutual funds that are highly liquid. These funds invest in debt instruments with a maturity period of not more than 91 days. Investors can withdraw upto Rs.50,000 as an instant redemption facility from some liquid funds. These funds are considered to be among the least risky within mutual funds.
2. Short / Medium / Long Term funds
   Short-term debt funds come with a maturity period of 1-3 years. These funds are suitable for investors with a low-risk appetite because their prices are not much impacted by the change in interest-rate movements also called as interest rate risk.
   
   Medium term funds come with a portfolio maturity of 3-5 years and long term funds come with a maturity beyond 5 years. Medium and long term funds are relatively more riskier than short term funds mainly because longer the tenure, larger is the impact of interest rates on the portfolio. This is also known as duration risk or interest rate risk.
3. Dynamic bond funds
   In dynamic bond funds, the fund manager changes the maturity of the portfolio depending upon their forecast on interest rates. If the forecast is for rising interest rates, the maturity is shorter. If the forecast is for falling interest rates, the maturity is longer. These funds come with a fluctuating maturity period. They invest in instruments that have shorter (1-3 years) as well as longer (3-5 years) maturities. These funds are slightly more riskier than short-term debt funds.
4. Fixed Maturity Plans
   Fixed Maturity Plans or FMPs come with a lock-in period. This period can vary based on the scheme you choose. You can invest in FMPs only during the initial offer period. After that, you cannot make further investments in this scheme. Many investors consider FMPs similar to FDs because both come with a lock-in period. However, unlike FDs, FMPs don’t promise fixed returns. However, FMPs are more tax efficient than FDs.

Who should invest in debt funds?

Debt funds are most suited for investors interested in moderate risk . The risk of investing in debt mutual funds is lower than in equity funds. If you have a lower appetite for risk, these funds can be a right choice for you.

You can also invest in debt fund if you have a surplus fund,. Another reason to invest in debt funds is to diversify your investment portfolio. This can be a good way to reduce the overall portfolio risk in case you have a higher equity allocation in your portfolio. The debt component can help to cushion any downside risk of returns.

How to invest in debt funds?

You can generally invest in a debt fund using two methods:

1. Lump sum investments
2. Systematic Investment Plans (SIP)

In case you have a considerable amount of money you wish to invest in one go, the lumpsum method is preferable. If you get a significant corpus of money, this is an appropriate option. However, you must choose a fund type basis your investment horizon or your goal.

If you want to invest smaller portions of money at regular intervals, a Systematic Investment Plan (SIP) can be a suitable alternative, use the SIP calculator to calculate returns on your investment. This is better matched for employees who receive a regular salary each month. Investing through the SIP route enhances your investment discipline while reducing your risk through rupee cost averaging which helps to buy more units when prices are low and less units when prices are high.

Steps to invest in debt funds in India

Over the past few years, investing in debt funds in India has become effortless. Here are the steps to begin your investment journey in debt funds:

1. Identify the debt mutual fund you wish to invest. You can base this on factors like the past performance of the fund, charges involved, pedigree of the Asset Management Company (AMC), performance track record / experience of the fund manager, etc.
2. Create an account with the AMC. These days, most funds allow investors to complete this step online.
3. Submit your KYC documents (if you have not already done so)
4. Specify the amount you wish to invest and the frequency of investment
5. Invest the amount on the selected dates and relax. You can also give online instructions to your bank to transfer the required amount into the fund on the specified date each month.
6. Monitor the performance of the fund regularly. If the fund’s performance is not up to the mark, you can shift your investment to another fund.

How to choose debt funds

There are various debt funds to choose from. Selecting the right fund from different options can get complicated. So, here are a few factors to consider before you select a fund.

1. Investment objective
   Before you select a debt fund, ask yourself the question: ‘What is my investment objective?’ do you want to create an emergency fund? As we have seen above, different types of debt funds cater to different investment goals. So, once you identify your investment objective, the process of selecting the right fund becomes easier.
2. Time horizon
   Every investment goal has a specific time limit. If you have a short-term investment goal of around 3 months to 1 year, liquid funds are preferable. If the tenure is between 1-3 years, you can go for short-term debt funds. But if you have an intermediate time horizon of 3-5 years, dynamic / medium term bond funds are more suitable.
3. Risk
   Debt funds also come with specific risks like credit and interest-rate risk. Credit risk occurs when the fund manager invests your money in securities that have a low credit rating. This can result in a higher probability of default. In case of interest-rate risk, bond prices could fall, when interest rates rise leading to poor returns on your investment. This is why it is essential to carefully check the fund’s history as well as the fund manager’s past performance before investing in any debt fund.

Conclusion

If you are looking for relatively stable income as compared to equities and limited exposure to market risk, debt mutual funds are an option worth exploring. You can choose among the different type of debt funds such as liquid funds, ultra-short-term debt funds, fixed maturity plans and many others to invest basis your investment goals and time horizon.