Choosing the right asset class to invest in depends on many factors. Your investment horizon, risk taking ability, existing corpus etc. are considerations which can decide, the asset class you have to invest.
There are various asset classes that as an investor you can invest in based on your risk/return preference. For some investors, returns would matter the most, while for others capital preservation takes precedence over returns.
A debt mutual fund is the investment avenue meant for people who prefer relatively lower risk.
What are debt funds?
Debt funds are a type of mutual funds, which invest in instruments of the debt market. These instruments include treasury bills, government bonds, money market instruments, commercial paper, certificate of deposits and corporate bonds.
These debt securities have a fixed periodic payment of interest and maturity date. The primary objective of debt funds is to try and provide returns with minimum volatility, when compared to equity mutual funds
Benefits of debt funds
Debt funds invest in securities, which have a fixed rate of return (payout of interest) and a maturity date. Furthermore some funds only have positions in investment grade bonds. Due to this there is less price fluctuations, and they’re not as volatile as equity investments.
In a fixed deposit, tax is applicable on accrual basis and is charged on your your total income. On the other hand, gains from debt funds are not taxed on accrual basis but added to your total income, only if your holding period is less than 3 years. The returns from debt funds, if held for more than 3 years are taxed at 20% after indexation.
Indexation: For investors who have remained invested in debt funds for over three years, the government takes into account the impact of inflation on your returns before charging taxes on them. Let us look at an example to understand this:
Let us say you invested Rs 100 in a debt fund on January 1, 2013 and wish to redeem these units at Rs 130 on January 1, 2016. Assume that after adjusting to current inflation level and taking into account the Cost Inflation Index (CII) as notified by the tax authorities, the cost of acquisition would be equivalent to Rs 115. Thus, your long-term capital gain on this transaction would be just Rs 15, and hence your tax liability will be lower.
An open ended debt fund can be redeemed any time, subject to an exit load (charges), if any. Even close ended funds can be traded on the exchange.
Under a Systematic Transfer Plan (STP), you can shift a monthly amount from your debt investments to other mutual fund schemes. This makes them more flexible as compared to traditional financial instruments such as fixed and recurring deposits.
Types of debt funds
These funds invest in debt securities issued by the government. These securities could either be issued by the central or the state government. The default risk is negligible, as it is backed by the government. These securities are affected by the interest rate risk due to the inverse relationship of bond prices with interest rates. Hence long term gilt securities are affected the most by interest rate movements.
Liquid funds invest in money market instruments, which include Treasury Bills, inter-bank call money market, Commercial Papers and Certificates of Deposit. These instruments are highly liquid in nature, which means you can redeem your investment in a short period of time.
Short term funds
Short term funds mostly invest in securities, with maturity of up to three years. They generally hold corporate bonds with good credit rating and have less exposure to money market instruments.
These funds invest across all varieties of debt instruments. Bonds, money market instruments, government securities and corporate debentures form a part of these funds. Such funds invest across different maturities and types of issuers.
Capital protection oriented funds*
As the name suggests these funds aim to protect your capital. Since, they try to protect your principal; they do not offer guaranteed results. These are close ended schemes and have fixed period of investment. These funds hold securities, which mature during the same time (i.e. at the expiry of fund period). They also have a low equity exposure so as to help you generate returns.
Fixed maturity plans
These plans have a fixed maturity and are closed ended. They invest in securities and hold them till maturity. This strategy reduces the interest rate risk and resulting fluctuations in price. Such funds can be purchased only during the New Fund Offer period and cannot be redeemed during the tenure of fund. They are traded on exchanges; hence liquidity is possible.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
*These schemes offered are “oriented towards protection of capital” and “not with guaranteed returns”. The orientation towards protection of the capital originates from the portfolio structure of these schemes and not from any bank guarantee, insurance cover etc. The ability of the portfolio to meet capital protection on maturity to the investors can be impacted in certain circumstances including changes in government policies, interest rate movements in the market, credit defaults by bonds, expenses, reinvestment risk and risk associated with trading volumes, liquidity and settlement systems in equity and debt markets. Accordingly, investors may lose part or all of their investment (including original amount invested) in these schemes. No guarantee or assurance, express or implied, is given that investors will receive the capital protected value at maturity or any other returns. Investors in these schemes are not being offered any guaranteed / assured returns.