Debt Mutual Funds

As we have seen in the previous articles, equity and hybrid mutual funds have certain benefits that may suit certain types of people as the risk involved in those types of funds is higher depending on the proportion of equity in the fund. However, in Debt Mutual Funds, even though there is no equity component, these funds are still exposed to risk.

So in today’s article, we will cover an in-depth view of Debt Mutual Funds.

What are Debt Mutual Funds?

1) Low Risk

As mentioned above, while debt mutual funds do not have any exposure to equity, they do carry the risk of underperforming as compared to other debt based investments. This is due to the fact that like other debt investments, debt mutual funds also face the problem of Credit Risk and Interest Rate Risk. Credit Risk is the scenario wherein the debtor cannot repay the amount promised, either with or without the Interest and the Interest Rate Risk is the risk of lowering the general Interest Rates.  So debt mutual funds are not completely Risk-free although they are much safer as compared to Hybrid or Equity mutual funds.

2) Fixed Return

Like most debt based investments, Debt mutual funds also provide a fixed rate of return which ranges from 7%-9%, depending on the performance of the fund. Due to the low risk in the fund, the returns have an Upper limit barrier and the rate most probably would not be able to go beyond that. However, the lower limit barrier could go lower as the general Interest Rates decline. But for those who wish to choose an investment with minimal risk and do not mind the fixed returns would ideally look towards Debt mutual funds as a good investment option as compared to others options.

3) Volume and Diversity

The added benefits of investing in a mutual fund are also available in a debt fund. So an investor can get the same benefits for a similar or lower price but needs to keep in mind that the Returns will be lower than that of an Equity or Hybrid fund.

The fund will invest in more than one debt based product such as Commercial Papers, Certificate of Deposit, Promissory Notes, Government and Corporate bonds, etc. So the investor gets the diversification of having a mix of multiple debt products rather than investing in a single debt product. They will also get the benefit of volume i.e. as there are many investors, the same products in the fund will be available cheaper than if invested by an individual. 

4) Taxation

Debt based investments also have a slightly better Taxation Policy as compared to most investments i.e. on profits made on the sale of units within 3 years, the same will be added to an investor’s income and taxed according to his/her slab (STCG) and profits made from the sale of units after 3 years will be taxed at the rate of 20%, but with indexation. 

Indexation is a concept which involves comparing the profits of a product to the price of it by giving the investor the benefit of inflation, the indexation value for each year beginning from 1980 is available on the internet and the value in the year of purchase has to be compared with the value in the year of selling the product.

Eg.1000 Units purchased of a debt mutual fund in 2012 at a NAV of Rs.250.

Therefore amount of purchase = 250 X 1000 = Rs.2,50,000/- 

And year of selling same units is in 2017, which is 5 years. Assume the NAV is Now Rs.300. Therefore the Amount received from the sale = 300 X 1000 = Rs.3,00,000/-

So taxable profit IS NOT = Rs.3,00,000/-  –  Rs.2,50,000/-= Rs.50,000/-.

We need to find the amount of Purchase with indexation. 

Let us assume that the Indexation value in the year 2012 is 125 and in 2017 it is 145.

Therefore the actual cost of purchase with indexation = (Indexation value in the year of selling / Indexation value in the year of buying) X amount paid during purchase.

= (145/125) X Rs.2,50,000/-

= Rs.2,90,000/-

So the Profit = Amount made on Sale – Actual Cost of Purchase with Indexation

= Rs.3,00,000/- – Rs.2,90,000/-

= Rs.10,000/- 

And 20% on that amount 

= (20/100) X 10000 

= Rs.2000/-

This proves to be a real deal for investors that are looking to target Debt products for post-retirement as most other investments either don’t have this benefit and even if they do, the returns are not similar to that of a debt mutual fund.

5) Short Term Goal Targets

 As equity and hybrid mutual funds are used to target long and medium-term goals, one can easily use debt based mutual funds to target short-term needs, like buying a bike or car in the next 3 years or expenses for regular medication and household expenses post-retirement, etc. 

As the rate is predominantly fixed an investor can easily realize the amount that has to be invested so that he/she can target their future short-term corpus. 

E.g., if a person wants Rs.5,00,000/- to buy a car in the next 3 years and looks at a Debt mutual fund that has a track record of around 9% in that time frame then he can easily find the amount he needs to invest.

PV (present value/investment amount) = FV (Future value/amount after 3 years/(1+R)^n 

Where R = the Rate of Return and n= no of years 

So as per the Amounts in the example

PV = 500000/ (1+9%)^3

= 500000/ (1+0.09)^3

= 500000/ (1.09)^3

=500000/1.2950

=Rs.3,86,100/- (Approx)

This is possible as one knows that the Rate of Return is fixed to a smaller range. In Equity this may not be as easy and depending on the proportion of the Equity component and the Performance of the fund, the returns could shoot up to 20%-30% at times but can also go as low as 5%-6% or even negative.

So we have seen that Debt mutual funds also have their pros and cons. Also the availability of funds and the time duration that an investor is ready to commit to determine whether an investment will be better off as an Equity or Hybrid or Debt Mutual Fund.

So investors should be clear about their goal and the duration of their investments and accordingly select funds based on how much of exposure to Equity the fund is willing to take on and also how much of Returns the Investor would need to meet their future goals.

Investment, in either case, can be done by the Lumpsum method or the SIP method, depending on the comfort level of an individual.

So stay tuned for our next article on LUMPSUM AND SIPS.

About the Author :

Rufino Dsouza is a Certified Financial Planner who specializes in  the following Services :

• Client wise portfolio management.
• Investment seminars. 
• Investment solutions and goal planning.
• Tax planning, and effective investment tools for the same.

His Contact details are as below :