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Tips to Start Investing in Debt Funds

With the FD (currently 6.25% for 1 year provided by SBI + the income tax based on your tax bracket) and other small saving schemes rates going down, people have started looking for other investment options which can provide better returns than FDs with low risk involved. So, here Debt funds come into picture which can provide returns in the range of ~7-9% with a low-risk profile.

Pros of Investing in Debt Funds:

  • Investment Tenure

There are different debt funds available in the market for different time periods. So, based on your investment timeframe and your risk profile, you can select a suitable fund.

  • Tax Efficiency

If you hold the investment for less than 3 years, then one will be taxed based on his/her tax slab but if you stay invested for more than 3 years, then the gains are taxed at 20% after indexation (i.e. one will be taxed 20% only on the gains over and above the inflation).

Let’s take an example – let’s say you earned 8% returns from your debt fund and the inflation increased by 5% in the same period as your investment, then you pay 20% tax only on 3% (8-5=3%), which is 0.6% (20% of 3%) versus 2.4% (30% of 8%) i.e. 4 times higher in an FD investment.

Therefore, the post-tax returns on a debt mutual fund are far superior to an FD.

Also Read: Tips to start investing in Equity Funds

Cons or Risks of Investing in Debt Funds:

  • Interest Rate Risk

Debt funds invest in various fixed income instruments and are mostly traded on the exchange helping to generate higher returns over and above the interest or coupon rate committed.

Now, whenever the interest rate drops as decided by RBI, the value of existing bond increases because it’s paying high-interest rate compared to the new bond issued after the rate cut. This leads to capital gains for the fund house.

Now, this interest rate risk is captured by the modified duration of the fund. Higher the modified duration, higher is the risk and higher are the returns.

So, if you want to take lower risks, select funds with lower modified duration.

  • Credit Quality Risk

The fixed income instruments in which the debt funds invest are all credit rated. Credit rating agencies like Crisil, etc. give a rating to all these instruments pointing out the creditworthiness of the borrower to pay interest and return the principal on time.

Higher the credit rating, lower the risk and hence lower interest rates the issuer pays and vice versa.

There is a possibility that a high rated instrument today gets downgraded tomorrow, in that case, the debt fund will still continue to receive the interest or coupon rate which was agreed earlier but the risk has increased now due to the credit rating downgrade and hence the instrument will start trading at a lower value on the exchange causing capital loss to the debt fund and vice versa.

So, to reduce the risk, always invest in high credit rated products.

  • Reinvestment Risk

It refers to the risk that the principal amount will have to be reinvested at a lower yield rate prevailing at the time of maturity. This is greatly influenced by the market interest rates.

If the interest rate is going down, investors face higher reinvestment risk and thereby lower returns.

So, to reduce reinvestment risk, one should stay invested for a longer duration.

Terms related to a Debt Fund to look at before Investing:

  1. The debt fund Portfolio gives a list of the instruments the fund has currently invested in, indicative of its investment strategy.
  2. Average portfolio maturity indicates the length of time until the principal amount of the bond is repaid.
  3. Duration of the portfolio indicates the price sensitivity of the portfolio to a given change in interest rates; a measure of the fund’s volatility.
  4. Average maturity and duration fluctuate depending on the view of the fund manager for flexible and dynamic debt funds. A fund with higher maturity and duration is expected to yield better results in a falling interest rate scenario and vice versa. This is because interest rates and bond prices are inversely related and longer the tenure of the bond, the more sensitive it is to changes in interest rates.
  5. The yield is a measure of the interest income earned on the bonds held in the portfolio.
  6. The maturity profile of the portfolio can be used to understand the composition of the portfolio.
  7. Returns can potentially be enhanced by lowering credit quality of the portfolio, which enhances the credit risk.
    The rating profile can be used to understand the credit risk.

Conclusion:

So, identify your goal and risk profile and the time interval for your investment and then based on that, select the ideal debt fund for yourself based on the parameters listed above.

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Let me know your thoughts on the comment below if you are planning to invest in Debt Funds.

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