What You Should Know Before You Invest in Debt Funds

Written by Himani Arora

Debt funds are those schemes that invest in debt instruments such as bonds, debentures, government securities (gilts), money market instruments, etc. and provide regular income to investors in the form of interest payments.

With buzzing uncertainties over the monetary policy of RBI (Reserve Bank of India), The position of debt funds is precarious. Apart from the future speculations, debt funds have performed poorly in the last financial year.

Naturally, debt funds were considered to be low-risk avenues, but the recent results show that investors are incurring unexpected losses. Therefore, if you are looking forward to invest in these funds but are alarmed by the facts, then you must keep the risk –return factors in your mind.

• There are further many choices in the debt fund arena. There are schemes which are security specific and others that are diversified. Types include long-term and short-term funds, credit opportunities funds, ultra short debt etc. Look into all the options before taking a decision.

• Government policies, central bank interventions and other economic factors affect interest rates. Make sure your expectations are correct. You should also have a good idea about the tendency of interest rate fluctuations for next few years.

• According to the new taxation rules, an investor will have to hold the funds for at least 36 months to qualify for the 20 per cent capital gains tax after indexation (inflation adjustment). If the fund is of short-term, then the gain will be taxed along with taxable income. Otherwise, there are tax advantages such as no TDS.

• Debt funds do not always offer assured returns. Short- term funds are not very volatile as monetary policy does not change frequently. Their return is roughly equivalent to the interest rate. But long-term funds are more sensitive to interest rate changes. In this scenario, not just income changes, but capital gains are also affected. Hence, such investors are advised to consider their investment horizon before investing.

• You should also know the maturity profile of funds, which will help you understand what percentage of the fund’s assets is invested in which maturity bonds. Using this profile, maximise your returns and lower your risk.

• Invest in fund that suits your needs. Considering your asset allocation is also necessary. Also, carefully analyse the credit profile to avoid credit risk and the average maturity to minimise domestic interest risk.

• When interest rates go down, NAV of funds go up. The effective increase in NAV will then depend on duration of portfolio (like 5 years) and hence determine your capital gains.

• Long-term debt funds perform best with SIPs. As they are less risky and give stable income, thus, a disciplined investment regime can be beneficial for long-term.

• Debt funds are not load-free. There are some funds that charge a penalty (0.5 – 2%) for exiting before the minimum period ranging from 6 months to 2 years.

• A knowledge of TDS is also necessary. Tax Deduction at source (TDS) aims at collection of revenue at the very source of income. An indirect method of collecting tax which combines the concept of “pay as you earn” and “collect as it is being earned”. TDS is significant for the government as prepones the collection of tax for, ensures a regular source of revenue, provides for a greater reach and wider base for tax.

• Apart from all this the investor must also be aware of the difference between “Debt Fund” and “Debt Instrument”. Let us simplify that for you.

What is Debt Instrument?

Document that serves as a legal enforceable evidence of a debt and the promise of its timely repayment. A debt instrument is an obligation that enables the issuing party to raise funds by promising to repay a lender in accordance with terms of a contact. Whereas debt funds are schemes that invest in them.

There is one major difference that you all should know i.e.

Debt funds often are perpetual with assets traded or replaced at maturity. As such there is no assurance of return of investor capital as the NAV will fluctuate with interest rate changes, both positively (when interest rates fall) and negatively (when interest rates rise). The longer the average duration (related to average maturity) the greater the opportunity for capital gain or loss.

Debt instruments have a maturity date at which time the face value of the bond will be paid. No matter how interest rates change during the term of the bond the coupon remains fixed and the value at maturity will not change.

Summing up, we suggest you not to follow yields (i.e. the interest income), but rather, focus on the overall return. By doing this, you can maximise the value of your investments. Evaluating debt funds is not so difficult but if you would keep these general ideas in your mind, then your investment in debt mutual funds can be a walk in the park.