Explaining Debt Funds

Debt funds may offer modest returns, but they do so with lower volatility. They may not give the highs of equity funds, but they save you from abysmal low too.

PROS
Less volatility. As debt funds invest in fixed income instruments, they are less volatile and their net asset values(NAV) don’t swing like those of equity funds. Expect moderate returns here with greater consistency and limited capital donside.

Consistent income, There are two components of debt fund income—interest and capital appreciation. As their underlying investment aim to pay a fixed income at fixed intervals by way of interest, debt funds aim to give consistent returns to investors.

Taxation benefits, Debt funds come with a tax advantage. While units of debt funds withdrawn before a holding period of one year is completed attract taxes as per your income tax slab(11.33, 22.66 or 33.99 per cent; inclusive of surcharges and cess), units withdrawn after a holding period of one year attract 11.33 percent tax.

CONS
Credit risk. Most debt instruments in the market are rate by credit rationg agencies, Ratings are denoted by letters--- ‘AAA’ rating is considered to be the highest and ‘D’ the lowest. A debt instrument’s credit rating reflects its capacity to earn intrest and provide timely principal payment. The higher the percentage of high-rated instruments in your debt fund, the safer it is.
Interest rate volatility. Intrest rates and bond prices are inversely related and change in rates can affect your returns. When interest ratesrise, prices of debt securities fall, and vice-versa, and thus, your debt fund’s nav.

Illiquidity. Corporte bonds are generally illiquid, unlike government securities. Also, lower the credit rating of a scrip, lower will be its liquidity. The performance of a debt fund with a larger allocation of lower-rated bonds gets impacted whtnit wants to exit them and can’t find enough buyers in the market.

There are two broad categories of debt funds: if the average maturity is more than a year, the debt fund is called long-term, and if it’s less than a year, short term.

LONG-TERM FUNDS

Bond funds. These invest in bonds or fixed income instruments issued by companies. Typically, their maturities ae beyond an year and provide steady income with little volatility. Debt funds are a good companion to retirees and senior citizens during a high interest rate scenario.

Gilt funds. These funds invest in G-seces-government securities issued by the Government of India. While long-term gilt funds invest in government securities maturing after a year, short-term ones invest in government securities maturing before a year, typically called treasury bills or T-bills.

Dynamic debt funds. These can alter their average maturity depending on their fund manager’s perception of the interest rate scenario. If the fund manager feels that interest rates will rise, he can raise the cash allocation up to 100 per cent, making these the riskiest of all debt funds.

SHORT TERM FUNDS

Short –term plans(STP). Also referred to as short-term bond funds, these are just like bond funds, but have an average maturity of less than a year, STPs have comparatively lower credit and interest rate volatility risk.

Liquid funds. These funds invest in debt instruments with maturities ranging from one day to three months. Liquid plus schemes, on the other hand, invest around half of their corpus in bonds maturing after a year.