All About Debt Funds For First-Time Investors To Know

After entering the job market, freshers have a common goal. The goal is to accumulate enough wealth by the time of retirement. To get enough wealth, a lot of people formulate a financial plan. As a part of the plan, people generally opt to invest in the market through a scheme referred to as mutual funds. In a mutual fund scheme, an AMC collects your money for a scheme and pools it in with the contributions of other investors. The pooled money is invested into different financial securities like stocks, gold, money market instruments, and bonds.

But just choosing a mutual fund scheme isn’t enough. In fact, there are several types of mutual funds that are available as an investment option. One of these different variants of mutual funds is debt funds.

What are debt funds?

This variant of mutual funds is known for primarily directing investments towards asserts such as debt and money market instruments. Debt funds are known for investing in things like treasury bills (T-Bills), commercial papers (CPs), and certificates of deposits (CDs). Also, things like non-convertible debentures i.e., NCDs and government bonds are prominent examples of debt market instruments. These funds are regarded as an ideal investment choice if your financial goal is to acquire a steady income for the future.

How do they work?

A financial expert managing your mutual fund portfolio who is referred to as a fund manager is known for allocating funds to assets such as debt or money market instruments. The fund manager takes this action with a single aim. The said aim is to enjoy revenue in form of interest payments. Unlike the other mutual fund variant equity mutual funds, debt funds are known for having significantly lesser risks. Significantly lesser investment risk is the reason why investors are attracted to these funds. Also, there are some variants of debt funds that can help you to invest even for one day or for some months. For example, overnight funds and liquid funds. In the case of overnight funds, funds are allocated to instruments that mature overnight. Liquid funds are known for allocating funds in securities that mature in less than 91 days.

Things about debt funds first-time investors to remember:

  • Interest rates keep on fluctuating:

Debt funds are fixed investments, and as a result, fixed investment securities are known for reacting inversely with the interest rates. This means that a rise in the interest rate will result in the lowering of the returns on the debt fund. Furthermore, the longer the maturity period a debt fund has, the higher the risk of fluctuation of interest rates. But investors might require a long investment horizon to reap better returns or to generate capital appreciation. While debt funds are subjected to the risk of interest rate fluctuations, they are known for offering the investors flexibility in entry and exit from the fund.

  • Check the credit quality:

It is of utmost importance to understand the debt fund holdings which are categorized based on the credit ratings given by rating agencies namely, AAA, AA+, and A1+. An AAA credit rating means there is lower risk and is best suited for conservative investors. Alternatively, debt funds that come with a lower credit rating can come with higher stakes and are suitable for investors who like taking calculated risks. It is recommended to opt for a fund that has the most high-quality bonds. Before opting for a debt fund, you need to do thorough research before considering an investment in debt funds that have a lower rating.

  • There are tax benefits if you hold on for a long time:

The duration for which a mutual fund is held will have an impact on the taxation benefits you can enjoy. If you were to redeem your debt funds for less than a year, you would incur a short-term capital gains tax. However, if you hold on to your debt funds for more than a year, there will be a long-term capital gains tax of 20% and will also include indexation benefits.