By: Tavaga Research
The market is saturated with debt instruments more so than equity instruments in terms of the market value of assets. Despite such a widespread presence, fixed-income securities or debt securities seem like uncharted territory for most investors. Debt Funds enable a retail investor to invest and gain exposure to the debt market.
Typically, debt funds are considered low-risk, but does that allow an investor to invest and forget? The article deliberates on the various factors surrounding debt funds.
Before diving into debt funds, let us establish the meaning of debt securities. Corporations raise capital through either equity or debt. Debt or fixed-income instruments provide returns in the form of fixed regular interest payments and principal payment (at the end of the maturity). An investor in debt security is essentially lending money to the company that is issuing the debt instrument for raising finance.
Government securities, treasury bills, corporate bonds, commercial papers, and other money market instruments are popular fixed-income securities.
Debt Funds are pooled investment vehicles, such as a mutual fund or an exchange-traded fund. Pooled investment funds create a pool of funds collected from investors and deploy the pool toward various securities across sectors. Therefore, a debt fund comprises fixed-income securities as its holdings.
Based on the theme of the fund, a fund may be comprised of short-term or long-term securities, and investment-grade or junk grade securities. Debt funds are sought by investors who look for portfolio diversification. Funds from this category also provide regular income in the form of coupon payments.
Debt funds also charge a lower expense ratio as compared to equity funds owing to lower management fees. Management fees are lower as there is less frequent churning of the fund portfolio.
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The two main variables while investing in debt funds are maturity and credit quality of the underlying debt securities. Debt funds can be broadly categorized in the following ways:
Fund Name | 1-Year Return | 3-Year Return |
IDFC Constant Maturity Fund | 9.79% | 11.95% |
Nippon India Gilt Securities Fund | 7.80% | 8.71% |
Nippon India Gilt ETF | 8.11% | 9.41% |
SBI Magnum Medium Duration Fund | 10.29% | 9.18% |
Kotak Dynamic Bond Fund | 10.24% | 9.23% |
Investors of debt funds can earn income by choosing either the growth option or dividend option. In the case of a dividend option, the earnings of a fund are distributed periodically. The growth option enables an investor to reinvest the accrued earnings from the fund to reap the benefits of compounding. The tax treatment differs under both options.
Dividend taxation: Dividends earned from debt funds are taxable in the hands of the investor. Dividend income is added to the total income of the individual and taxed as per the applicable tax slab rate. Earlier, Dividend Distribution Tax (DDT) for debt funds used to be 29.12 percent for debt funds. With DDT abolished, an investor stands to benefit if a lower tax slab rate is applicable.
Capital gains taxation: Capital Gains are taxed differently for short-term (STCG) and long-term capital gains (LTCG). The threshold is 36 months. In the debt fund category, a capital gain that is made beyond 36 months is considered as long term capital gains and if the holding tenure is less than 36 months, it is a short term capital gain.
Indexation Benefits Gains arising from a debt fund are calculated by subtracting the cost of purchase from the current market value of the units. STCG is calculated simply using the formula.
However, LTCG offers an indexation benefit. The cost of purchase is indexed to the present inflationary conditions in the economy. LTCG can reduce the tax liability of an investor. The gains arising over the long-term are not overstated by a reduction in the difference between the indexed cost of purchase and the current market value.
As the name suggests, debt funds primarily invest in debt securities and equity funds invest in equity instruments of different companies.
Debt funds and Fixed deposits are similar in that both the investment options offer fixed returns for assuming a relatively lower risk. However, an individual must be aware of the factors that can make a difference:
While debt funds are considered to be low-risk investments, various types of risks are still prevalent in such securities:
Speaking of risks involved in debt funds, it seems customary to mention the Franklin Templeton debacle that recently surfaced. Franklin Templeton AMC had large scale exposure to companies that defaulted on their debt obligations. As a result of such defaults, the AMC had to shut some of their debt schemes. The debt schemes faced a massive single-day fall in their NAVs on the announcement. The closure of schemes, even though voluntary, was based on illiquidity in the markets. Illiquidity also built up redemptions pressure as the fund could not process the redemption requests of the unitholders.
Investment in debt funds has to be as per the investment goals of an individual as this category offers a wide range of instruments (ranging from 1 day to 10 years). While it is true that debt funds offer many risk-free investment options for an investor to choose from, it is highly recommended to check the expense ratios of all these risk-free funds. Gilt ETF is one of the instruments that offer a relatively lower expense ratio with higher returns in a low-interest rate regime.
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