What Are Debt Funds And How do They Work?

Debt mutual funds offer you better tax efficient returns as compared to PPFs, bank FDs and post office saving schemes while giving you an opportunity to invest in the debt asset class that has similar characteristics as some of these traditional investment options.

These days lots of people are adding mutual funds to their consideration set as far as financial planning is concerned. And why not? Mutual funds are a good way to invest for getting better returns than conventional investment avenues like PPFs, bank FDs, post office saving schemes and even ULIPs. Mutual funds are extremely convenient for retail investors to invest their hard-earned money in and have it managed professionally by expert fund managers.

If you are still skeptical about investing in mutual funds, you can consider investing in debt mutual funds that are comparable to the conventional avenues but offer better returns in terms of tax efficiency. You surely know that the interest income from your bank FDs are taxed at the highest tax slab applicable to you as an individual right? Well, with debt funds, you tax liability is lower. We’ll tell you that in a bit but for now let’s cover some basics.

Debt funds, as the name suggests, are a category of mutual funds that primarily invest in the debt asset class comprising of bonds issued by PSU banks and other PFIs (Public Financial Institutes like NBAARD, LIC HFL etc), corporates bonds, bonds issued by the govt. and its various agencies like the RBI, National Highway Authority etc. Most debt funds also invest in money market securities like T-bills, bank CDs, commercial papers that are traded in the market. As you can see, these debt mutual funds belong to the same asset class as your conventional options and they invest in pretty much similar kind of securities. It’s just that debt mutual funds don’t guarantee a return like your bank FD or PPF does. But they also have the potential to offer higher return than this fixed guaranteed return promised by your bank.

Within debt mutual funds, you again have a variety to choose from. Suppose you just don’t want to take any chances with your money. Then go for a Govt securities debt fund that primarily invest in securities issued by the govt. and its various agencies. If you have got some surplus cash with you, go for a liquidity fund to park this surplus till you finally decide what do you want to do with this cash. So instead of leaving it idle in your savings account, a liquidity fund is a better option where you can earn some extra return compared to a savings account. Liquidity funds allow you to invest for very short duration ranging from few days to few months and do not charge an exit load when you redeem your investments.

Then you have the option of choosing the best debt funds for long/short term depending on how long you wish to stay invested. These funds vary in terms of their portfolio holding. While short term funds invest in debt and money market securities most suitable for a short investment horizon, long term funds can invest in debt securities with a slightly longer time to maturity.

There is another class of debt funds that focus on giving regular income to their investors in the form of monthly dividends. These funds invest in highly rated debt securities that offer a regular stream of income via coupon payments from the underlying debt holdings. Retirees or investors looking for regular income can research for the best debt funds under the income class within the category of debt mutual funds.

As you must have figured out by now that debt mutual funds offer you a much wider range of choices ranging from investing in G-securities and treasuries to corporate bonds and debentures to highly liquid options. You surely don’t have such choices in other investment options like the traditional bank FDs or PPFs.