What is debt?

Debt refers to the amount of money borrowed by one party (borrower) from another party (lender). The borrower agrees to repay the borrowed money at a future date along with the interest. Generally companies, banks and governments raise debt capital from the public in order to meet their working capital requirements and for their business expansion & acquisition of other companies. They borrow money through various debt instruments like government securities, Treasury bills, PSU bonds, certificates of deposit, commercial paper and corporate bonds etc. Debt can be short-term or long-term.

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There are 2 types of debt:

Secured debt – It is secured against the assets of the company. If the borrower defaults then the lender can liquidate or sell the asset in order to get his principal and interest amount.

Unsecured debt – It is not secured against the assets of the company. Generally, the lender lends money based on the borrower’s creditworthiness.

The cost of debt is lower when compared to raising equity as they are low-risk instruments than equity. At times of bankruptcy or insolvency the company is obligated to repay the debt to the investors. Too much debt is also risky for a company, it should decide the adequate debt-to-equity ratio based on its financial position and assets & liabilities. Generally, the debt-to-equity ratio for a company should be less than 1.

Also read: Do you have your Retirement plan in place?

What is a Debt Mutual Fund?

A debt Mutual Fund scheme invests in fixed-income instruments, such as government securities, Treasury bills, PSU bonds, certificates of deposit, commercial paper and corporate bonds etc. that offer capital appreciation and generate interest income.

Why invest in a debt mutual fund?

  • If your investment horizon is 1 day to up to 3 years then debt funds is a good option.
  • They offer better post-tax returns compared to FDs and savings accounts.
  • You will get an indexation benefit if you stay invested for at least 3 years. Indexation benefit means the cost of acquisition can be inflation-adjusted which will reduce the tax liability.
  • Liquid Debt Funds are a great option to park your emergency funds and funds required for your short-term goals. You can earn better returns than savings bank accounts & FDs without taking too much risk.

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Types of debt mutual funds;

Debt mutual funds are categorized into various types based on the securities they invest in and the tenor of those securities. They are :

  • Overnight Funds – They invest in debt securities that mature in 1 day. These are highly liquid and safe like savings accounts.
  • Liquid Funds – It invests in money market instruments with a maturity of up to 90 days, like treasury bills and commercial papers
  • Ultra-Short Duration Funds – It invests in debt securities with a Macaulay duration of 3-6 months. They provide Higher returns than FDs
  • Low Duration Fund – It invests in debt securities with a Macaulay duration of 6-12 months
  • Money Market Funds – They invest in money market instruments with maturities of up to 1 year
  • Short Duration Funds – It invests in debt securities with a Macaulay duration of 1-3 years.
  • Medium Duration Funds – It invests in debt securities with a Macaulay duration of 3-4 years.
  • Medium-to-Long Duration Funds -These invest in debt securities with a Macaulay duration of 4-7 years. They carry high-interest rate risks and can be invested in falling interest rates.
  • Long-Duration Funds – It invests in debt securities with a Macaulay duration of more than 7 years. They carry high-interest rate risk but are less risky than equity.
  • Corporate Bond Funds- It invests a minimum of 80% of its funds in high-rated corporate bonds which are safe and have the potential to generate good returns.
  • Banking & PSU Funds – It invests 80% of its funds in debt securities of banks, PSUs, and PFIs.
  • Gilt Funds – It invests at least 80% of its funds in government securities with different maturity periods. The default risk is lower in these funds, however, they are subject to high-interest rate risk.
  • Gilt Fund with 10-year Constant Duration – It invests at least 80% of its funds in G-secs with a 10-year maturity.
  • Dynamic Funds –It invests in Debt Funds securities across maturities according to the prevailing interest rate cycle in the market.
  • Credit Risk Funds – It invests at least 65% of total funds in the below-highest ratings corporate bonds. these bonds pay higher interest rates as there is higher default/credit risk associated with the bonds.
  • Floating Rate Funds – It invests in floating rate debt securities which do not pay a fixed coupon and their coupon rate is linked to a benchmark.

Indexation Benefit: The investor will get the indexation benefit if the debt mutual funds are held for more than 3 years. The purchase price of the debt mutual funds is adjusted against inflation, hence the capital gain gets reduced.

Taxation: If the debt funds are held for more than 3 years, then they will be treated as long-term capital gains and taxed at 20% with indexation benefit. If the debt funds are held for less than 3 years, then they will be treated as short-term capital gains and taxed as per individual tax slab rates.

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Debt funds are less volatile and more stable than equity funds but they do carry a certain amount of risks like credit risk and interest rate risk. Sometimes fund managers may invest in low-quality debt instruments to generate higher returns which may lead to credit risk.

Interest rate risk arises due to interest rate fluctuations in the market. Long-term debt mutual funds are more sensitive to interest rate fluctuations when compared to short-term debt funds. The NAV of debt funds fluctuates with changes in the interest rate. If the interest rates rise, then the NAV of a debt fund falls and if the interest rates fall, then the NAV of a debt fund rises. Therefore the bond prices have an inverse relationship with interest rates.

Who can invest in debt mutual funds?

  • Investors with low to moderate risk tolerance can opt for debt funds as they are less risky when compared to equity.
  • Investors seeking to have a regular and steady income can opt for debt mutual funds.
  • Investors can park the funds required for their short-term goals in debt MF to ensure liquidity and safety.

Disclaimer:

This article should not be construed as investment advice, please consult your Investment Adviser before making any sound investment decision.

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Also read: Market Outlook September 2022



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