Debt investment has been the subject of much debate since humans began investing in the financial world, particularly when compared to other investment options such as equities or real estate. While equity investments are known for their better returns, debt investments have their own set of advantages.
In general, if you have some spare cash and want to invest it in the stock market, you have two choices. The first is to buy something at a certain price with the intention of selling it later for a bigger profit. Stocks, mutual funds, real estate, commodities, and derivatives are examples of investment alternatives.
Another option is to lend your savings to another person (or group) and receive interest until your corpus is returned. Bank Savings Accounts, Bank Fixed Deposit Accounts, Corporate Bonds, Government Bonds, and Debt Mutual Funds are all examples of this.
In this piece, we’ll go over what debt investments are (with a focus on debt mutual funds), the many types of debt funds, their advantages, and more. However, before we get into it, let us first review the fundamentals of lending.
There are two parties involved in the financing process. The lender lends the money to the borrower since the latter is in need of it. For using the funds, the former makes a periodical payment known as “interest” to the latter. When the borrower repays the total amount due to the lender, the loan is closed. ‘Loan’ is also known as ‘credit,’ ‘debt,’ or ‘bond’ in this context. Because the interest rate, maturity period, debtor, and creditor are all predetermined, these products are referred to as “fixed-income securities.”
What are Debt Mutual Funds and how do they work?
You are essentially lending money to the issuing organization when you invest in a Debt Mutual Fund. You can generate income in the form of interest and capital appreciation by investing in a Debt Fund. On Debt securities, you earn a pre-determined interest rate for a set period of time after which the debt instrument matures. Debt securities are also referred to as ‘fixed-income products’ because you know exactly what you’ll get.
In the case of debt funds, the fund managers invest in a variety of securities. This provides considerable opportunity for Debt Funds to make respectable returns. Despite the fact that no one can guarantee the same, debt fund rates tend to fall in a predictable range. This piques the attention of cautious investors in Debt Mutual Fund Investing.
A Debt Fund’s underlying assets are often financial instruments with a better credit rating. In comparison to low-rated assets, Debt Funds investing in higher-rated financial products will be less volatile.
It’s worth noting that the underlying’s duration (maturity) is determined by the Fund Manager’s investment strategy as well as the current rate of interest in the economy. If the market interest rate declines, the Fund Manager may switch the underlying investments from short-term to long-term securities, or vice versa. The maturity length of the underlying investments is the primary differentiating aspect among the various Debt Funds.
Divisions of Debt Funds
1. Dynamic Bond Funds: The portfolio composition of these funds is constantly changing in response to the changing rate of interest in the economy. The underlying portfolio is churned according to the rise and fall in interest rates in the economy, hence the average maturity length of this fund varies.
2. Income Funds: These funds are similar to Dynamic Bond Funds, but the underlying portfolio of Income Funds is often made up of assets with long-term maturities. When compared to Dynamic Bond Funds, this gives Income Funds better stability.
3. Short-Term & Ultra-Short-Term Debt Funds: These funds invest in short-term and ultra-short-term debt securities. They are less likely to be affected by interest rate swings due to their short-term nature.
4. Liquid Funds: These funds invest in fixed-income assets that have a maturity period of fewer than 91 days. These funds appear to be a superior alternative to maintaining one’s cash in a savings account. This is due to the fact that the former offers similar liquidity at a larger return.
5. Gilt Funds: These funds invest exclusively in government bonds. Government instruments have a high credit rating, which means they have a low credit risk. Gilt Funds are therefore appropriate investment options for risk-averse individuals who also wish to invest in debt assets.
6. Credit Opportunities Funds: These funds invest in credit risks in order to obtain larger returns. The goal of these funds is to invest in lower-rated bonds with greater interest rates. Credit Opportunities Funds have a higher risk profile than Debt Mutual Funds.k
7. Fixed Maturity Plans: These are closed-end Mutual Funds that invest in debt securities and have a lock-in period. During the initial offer period, you can invest in Investments FMPs. An FMP is comparable to a fixed deposit in that it provides great tax-efficient returns, but it does not guarantee those returns.
Who should put their money into Debt Mutual Funds?
Debt Funds are an excellent investment option if you are a cautious investor. You can also invest for a short period of time, ranging from three months to a year. Debt Fund investing can also be done over a medium period of time, ranging from three to five years.
If you want to invest for a limited period of time and are concerned about liquidity, Liquid Funds may be a better option than putting your money in a savings account. Investing in the former will provide you with nearly double the profits that a Bank Savings Account may provide.
Dynamic Bond Funds are a good option for medium-term investing. Investing in such a Debt Fund will yield more returns than a 5-year bank FD. Monthly Income Plans are a good way to earn a consistent income (MIP).
How can investing in Debt Funds assist you?
A great place to start: Your income and savings may be low throughout the early stages of your profession. You may be undecided about where to put your small savings. A debt fund would be a wonderful place to start your financial journey. Gradually, you’ll have a better understanding of investing, risk-reward relationships, and financial planning, and you’ll be able to diversify your portfolio.
1. Increasing the stability of your investment portfolio: Debt Mutual Funds invest mostly in debt products. As a result, they are a more reliable financial instrument than stock investments. Debt Funds can help to stabilize your equity portfolio by spreading the risks in your present investing portfolio.
2. Long-term growth: A Debt Fund investment would yield an annual return of roughly 8% while posing no major risk. Furthermore, if you retain your investment for longer than three years, you will profit from indexation. Indexation allows you to use the cost inflation index to boost the buying price. To calculate a long-term capital gain, the purchase price is increased (adjusted for inflation) and removed from the sale price. This, of course, lowers your taxable capital gains. In other words, if you redeem your assets (partially or entirely) after three years, your capital gain returns will be more tax-efficient than if you put your money in a Fixed Deposit Account.
3. Helpful in paying unexpected expenses: You should always have a fund set aside to support yourself in the event of an emergency. Having an emergency fund can come in handy in times of need. In this case, debt funds are a wonderful option to put your emergency funds in a savings account because they offer similar liquidity, low risk, and better returns.
4. Cash: Debt funds provide you with quick liquidity. You can continue to invest your paychecks in a Debt Mutual Fund and withdraw your money at any time. If you want to meet any of your needs, you can put your money in a Debt Fund and then sell it.
Things to think about before investing in a Debt Fund :-
1. Debt Funds are not completely risk-free: Debt Funds are riskier than Fixed Deposits since they are linked to both credit and interest rate risk. Credit risk arises when the Fund Manager selects low-credit-rated products for the underlying portfolio. Furthermore, interest rate risk exists, in which the price of bonds may fall due to an increase in interest rates.
2. Fees: Debt funds charge a fee for handling your money. A cost ratio is a term for such a fee. According to SEBI, the expense ratio cap is set at 2.25 percent. Although the upper limit of the expense ratio may appear to be unfavorable, over the long term, this will undoubtedly assist you in creating even more money than you have paid in the expense ratio.
3. Returns are not guaranteed: A Debt Fund’s underlying portfolio is made up of fixed-income securities, however, they do not guarantee any returns. If interest rates in the economy as a whole rise, your Debt Fund’s Net Asset Value (NAV) will fall. As a result, you can find Debt Mutual Funds appealing to invest in when interest rates are falling in the market.
4. The longer the holding period, the better the returns: You can invest in Debt Funds for any time horizon that suits your needs. It should be remembered, however, that the longer the investment horizon, the greater the chance of achieving favorable returns.
5. Achieving long-term objectives: You can achieve a variety of financial objectives by investing in a Debt Fund. Debt mutual funds can be used to supplement your monthly wage as a passive source of income. Furthermore, if you are a novice investor, you may consider investing some of your funds in Debt Funds to meet your liquidity needs. When you retire after about three decades, on the other hand, you can consider investing the majority of your retirement benefits in a Debt Mutual Fund to receive a regular pension.
6. Don’t forget about capital gains taxes: When you redeem your Debt Fund units, you will receive income, which is referred to as capital gain. The profit on the sale of a home is taxable. The rate of capital gains taxation is determined by the length of time you hold your units in such a fund.
A short-term capital gain is a capital gain that you make over a period of less than three years (STCG). Long-term capital gains, on the other hand, are the gains you make when you redeem your units after holding them for three years or longer (LTCG).
The STCG you make is added to your net income, which is then taxed according to your income bracket. After factoring in the effect of indexation, the LTCG you earn will be taxed at a rate of 20%.
If you’re new to financial market investing and have a low-risk tolerance, Debt Mutual Funds are a great place to start.
As you advance in your job, your earnings rise, and your risk appetite rises with it. Your investment continues to grow, while the proportion of Debt Fund in your investment portfolio decreases. When you retire, though, you will be looking for a steady source of income, and your financial assets may appear to be debt-laden once more. As a result, your investment adventure begins and concludes with Debt Fund. As a result, you can’t afford to overlook the significance of the same in your working life.
So, you’re new to the financial world and want to put your money into low-risk investments? Have you begun planning for your future? What are you waiting for if you haven’t already? Debt Mutual Funds are a great place to start your investment adventure. Good luck with your investments!
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