Investing in a well-diversified debt fund is a smarter investment decision as compared to conventional options available in the market.
Capital Market is one of the most popular ways of multiplying wealth as it offers numerous investment instruments that help you in achieving your financial goals. The capital market offers investment instruments like mutual funds which have different funds such as debt funds, equity funds and hybrid funds for investors, as per their risk appetite. However, capital markets are often used as synonyms of equity market, which is not entirely true. Debt instruments play a very important part in the market as well and need to be a part of every healthy financial portfolio.
This article will help us understand the importance of debt funds and why investing in a well-diversified debt fund is a smart choice.
What is a debt mutual fund?
Mutual fund companies gather money from various investors and invest this accumulated corpus in stocks of various companies and generate income for their investors. However, the investors need to choose a scheme for investment as per the asset allocation, risk profile and the investment objective of the scheme.
A mutual fund company invests in all types of investment instruments namely: equity, debt and combination of both. The risk and the returns on investment depend on the type of the fund you opted. Thus, for investors who seek fixed interest and fixed return opportunities, investing in a debt fund is a smart choice.
Debt mutual fund invests the accumulated corpus of investors in instruments that are less risk-prone and offer fixed interest. The most common example of debt instruments is – corporate bonds, treasury bills, commercial papers, etc.
The entire trick of debt investing is choosing a well-diversified debt fund so that risk is further diversified among the products and there is no inherent risk associated with the same.
Why invest in debt fund?
Debt fund investment offers a lot of advantages, but not many are inclined towards investing in debt mutual fund. So, here is a list of reasons that will help you understand that investing in debt fund instruments is a profitable and smarter choice as compared to other instruments offering fixed returns.
Medium Term Investment Horizon: Investment Horizon refers to the tenure for which an investor wishes to invest the corpus and the timeline within which the investor intends to achieve a financial goal. The investment horizon for debt fund instruments is beneficial for short term investments like three year to five years.
Low Risk: The main objective of investing in a debt fund is that this instrument has very little risk associated with it. Investing in the equity market attracts volatility, but in order to stabilize your risk factor, some investors prefer to invest in debt fund as the risk exposure for these instruments is very little.
Even so, investing in debt funds is not entirely risk-free as they face two types of risk i.e. Credit Risk (associated with the credit rating of the company issuing these bonds) and Interest risk (where the value of related instrument decreases due to increase in the interest rate of the instrument).
- Stable Returns: Debt mutual funds invest in instruments that offer fixed returns like – commercial papers, treasury bills, corporate bonds etc. These instruments offer stable returns.
The returns offered by the debt fund is more as compared to conventional investment instrument like bank fixed deposit receipt.
- Tax Liability: Returns earned by investing in the capital market is subject to be taxed under the Income Tax Act.
a. Short Term Capital Gain Tax is applicable on the returns earned on the investments done in debt fund schemes for shorter tenure i.e. less than 3 years.
b. Long Term Capital Gain Tax is applicable on the returns earned on mutual fund schemes held for longer tenure i.e. above 3 years. Long-term investments, i.e. more than 3 years, get the benefit of indexation as well and hence, it becomes tax efficient as a product.
- Portfolio Stability: Investing in a debt fund is advantageous as it brings stability to the investment portfolio. Debt fund schemes offer an advantageous opportunity to stabilize portfolio by insulating the risk and volatility of the capital market.
- High Liquidity: The debt funds offer high liquidity i.e. the investor has the freedom to withdraw the money from the debt fund mutual scheme as per the financial need and convenience of the investor.
However, certain funds have a charge to exit the fund before 1 to 3 years called the exit load.
Diversification of Investment Portfolio: As mentioned earlier, the basic nature of the debt fund mutual scheme is less risky and stable. Therefore, this investment instrument can be utilized as a smart choice for diversifying your investment portfolio. Including a debt fund in your investment portfolio will help you insulate the effects of market volatility and fluctuation.
Financial Goal: Investing in a debt fund scheme is beneficial for new investors and investors who are looking for an alternate but steady flow of income for achieving financial goals.
How does a debt fund work?
A mutual fund is a pool of money that is invested in various investment instruments namely debt, equity etc. Fund Managers are responsible for making such an investment. A fund manager invests investors’ money in debt instruments based upon their credit ratings. A credit rating is a way to understand whether the issuer will honour the returns promised on the debt instrument. Higher the credit rating, higher are the chances of honouring the returns and principal amount on the maturity date.
Thus, a fund manager invests in a debt instrument and you receive interest or dividend on them during the tenure of investment or at the time of maturity along with the principal amount.
Who should invest in debt fund?
Debt fund instrument is best suited for the risk-averse investor. Investors should invest in debt fund scheme who:
Want steady flow of return (even if the returns are low as compared to the equity counterparts),
Have surplus funds which they want to invest for higher returns and greater tax efficiency than traditional investment products like bank fixed deposit or savings account,
Does not wish to invest in a high-risk investment instrument.
Thus, investing in a well-diversified debt fund is advantageous as it offers diversification to your investment portfolio, thereby mitigating the capital loss risk. Similarly, including debt fund investments in your investment portfolio will provide a proper cushion against the volatility of the capital market and fluctuation of equity mutual fund.
Investing in a well-diversified debt fund thus not only helps in overcoming the risk of loss of capital involved in an equity fund, but also provides a peace of mind. Moreover, if the financial goal is short term, debt investing is surely a much smarter option compared to an equity fund.
Recommended Read: What are Hybrid Mutual Funds?