What is debt-oriented Mutual Fund? Meaning, types and benefits

A debt oriented mutual fund is a mutual fund scheme that invests in fixed income instruments, such as bonds issued by the government and corporate, debt securities, and money market instruments, etc. These mutual funds are a popular investment option and are great for investors who do not have a huge risk appetite but want steady returns. Debt mutual funds are referred to as fixed-income securities as the investor is aware of the returns to be received from the investment right from the time of the investment. These funds are insulated from market volatility and therefore considered less risky than equity funds. Debt oriented mutual fund offers tax benefits as well which makes them a popular investment option.

However, it is important to note that opportunities for capital appreciation are restricted in a debt-oriented mutual fund. The NAVs of such funds can be affected due to a change in interest rates. In case of a decline in the interest rates, NAVs of such funds are likely to increase in the short run and vice versa.

How does debt oriented mutual fund work?

The investment money in a debt mutual fund is invested in various debt securities. These securities have a fixed maturity date & pay a fixed rate of interest. The type of debt security is selected by taking into account the credit rating of the issuer, which is a tool to determine the risk profile of the security and is an important criterion for evaluating the creditworthiness of the issuer. The ratings reflect the ability of the issuer of the securities to repay the debt. Independent rating organizations such as CARE, CRISIL, FITCH, Brickwork and ICRA issue the ratings. The fund manager has the responsibility to invest in highly rated instruments to generate the maximum returns for the investor. Investment in higher-rated securities is less volatile when compared to low-rated securities.

The maturity period of these investments depends on the investment strategy of the fund manager as well as the interest rate regime in the economy. If the interest rate is declining, the fund manager would usually consider investment in long-term securities. If the interest rate is appreciating, the fund manager would consider investing in short-term securities.

A debt oriented mutual fund can invest in either listed or unlisted debt instruments. The increase or decrease in the NAV of the debt fund is determined by the difference between the cost and sale price of the unit. As the investment is done in instruments that offer a rate of interest, investors are eligible to receive periodic interest from the investment. Debt funds that earn regular interest from the fixed income instruments during the fund’s tenure work like the deposits made with the bank.

Types of debt-oriented mutual funds

There are different types of debt funds depending on the investment horizon and the risk appetite of the investor.

Liquid & Money Market Funds: As the name suggests, the investment is made in highly liquid money market instruments and debt securities. The tenure of such instruments is usually short and can be held for just one day also. Examples of such instruments include Treasury Bills, Commercial Paper (CP), Certificates Of Deposit (CD) and Collateralized Lending & Borrowing Obligations, etc. The primary aim of these funds is to earn money market rates. It is a popular investment avenue for investors who want to park their surplus cash for a short period.

Income funds: These funds primarily invest in an array of debt instruments of various maturities & issuers. The investment is usually done in instruments that have medium to long-term maturities. Income funds are suited for investors who have a higher risk appetite and longer investment horizon.

Short-Term funds: These funds primarily invest in debt instruments which have shorter maturity or duration. The usual maturity period is up to 3 years. These funds generate good returns when the short term interest rates are high. The popular instruments in this category include debt and money market instruments and government securities. The investment horizon of these funds is longer compared to liquid funds but shorter than medium-term income funds. These funds are best suited for investors with a low to moderate risk appetite and an investment horizon of 9 to 12 months.

Floating Rate funds (FRF): As the name suggests, these funds primarily invest instruments that offer a floating interest rate. The primary objective of the fund is to minimize the volatility of investment returns. Floating rate securities are linked to a benchmark rate for debt instruments such as MIBOR. The interest rate is reset periodically based on the interest rate movement. Accordingly, the returns vary.

Benefits of debt-oriented mutual funds

Here are the key benefits of investing in these funds:

Immune from market volatility: Unlike equity mutual funds, a debt-oriented mutual fund is not subject to market conditions. Investments are made in securities with a fixed maturity period and a rate of interest.

Stabilized your portfolio: Since the risk associated with debt instruments is lower than equity instruments, these schemes provide stability to your portfolio.

Great for new investors: New investors usually start with a low-risk appetite. Debt oriented mutual funds serve as a great avenue of investment for such investors.

High liquidity: Investment in these funds can be good way to invest surplus cash to build an emergency reserve. If you are in need of urgent liquidity, you can always redeem the investment.

Helps to achieve investment goals: Debt funds have a fixed maturity period and offer a steady return. If you have a short term investment objective for building a corpus for travel fund or any other expenses, debt-oriented mutual funds is a great option.

How are debt oriented mutual funds taxed?

Taxation plays an important role for the investor while deciding on the type of scheme to be invested in. There are two types of taxes associated with a debt fund: dividend distribution tax and capital gains tax. The capital gains taxation for debt funds is similar to the taxation for equity funds. However, the definitions of long-term and short-term investments are slightly different in case of debt-oriented mutual funds.

Dividend distribution tax: The returns from a debt mutual fund are subject to a dividend distribution tax which has the following components: dividend for individual v/s non-individual investors and the dividend from liquid v/s non-liquid funds. The present rate is 28.33 percent (including surcharge and cess). The fund house deducts the DDT from the interest income before crediting it in the account of debt mutual fund holders. This reduces the in-hand return for the investor. However, the dividend from a debt mutual fund is tax-free at the hands of the investor.

Capital gains tax: Any sale of a debt mutual fund results in a capital gains tax. There are two types of capital gains tax depending on the holding period of the debt mutual fund prior to the sale.

If you sell the debt mutual fund after a holding period of 3 years, the capital gains arising from the transaction is a called a long-term capital gains. The tax rate is 20.8 percent with the benefit of indexation. Indexation refers to the process of adjusting inflation against the purchase price of an investment. To illustrate, if you have invested in a debt fund for over three years, you are liable to pay tax only on the returns over and above the inflation-adjusted initial investment. This makes debt funds more attractive compared to other fixed-income investments such as a fixed deposit.

If you sell the debt mutual fund in less than 3 years, the capital gains arising from such transaction is called a short-term capital gain. The taxation is as per the income tax slab of the investor.

If your investment is in an international fund (where the investment is made in stocks abroad) (which invest in stocks abroad), it is considered as a debt fund. Any gains or returns from such international funds are taxed as per the rules applicable to debt funds.

FAQs

Is it possible for the NAV of a debt mutual fund to fall?

Debt mutual funds invest in fixed income securities. However, while the rate of interest is pre-determined, the market value of such interest rate varies. This depends on how the interest rates in the economy perform. The NAV of a debt fund is the market value of its portfolio holdings at a given point in time. If the interest rate in the market changes, the market value of fixed-income instruments also change. This impacts the NAV of a debt fund.

What is a Fund of Funds (FoF) scheme?

FoF refers to a scheme that invests primarily in other schemes of the same mutual fund or other mutual funds. Such schemes enable investors to achieve greater diversification through one scheme. The risk profile is reduced as the investments are made across different funds.

I have invested in a debt-oriented mutual fund scheme. Is it possible that the mutual fund changes the nature of the scheme from debt to equity?

It is possible to change the nature of the scheme. However, SEBI has laid down certain regulations which need to be complied with for affecting such a change:

Any changes in the fundamental attributes of the scheme such as the structure, investment pattern, etc., can be changed only when written communication is sent to each unitholder and an advertisement is given in one English daily newspaper having nationwide circulation. The information should also be published in a newspaper published in the language of the region where the head office of the mutual fund is situated.

In case the unitholders do not want to continue with the scheme, they have the option of exiting the present scheme at prevailing NAV without bearing exit load.

How can I know where the mutual fund scheme has invested the investment money?

As per SEBI regulations, every mutual fund has the obligation to disclose full portfolios of all of their schemes on a monthly basis on their website. Portfolio disclosure on a half-yearly basis is published in the newspapers. The fund house can also send the disclosure of half-yearly portfolios to their unitholders.

The scheme portfolio has the details of the investment made in each security i.e. equity, debentures, money market instruments, government securities, etc. and their quantity, market value and quantum of the NAV they account for. These portfolio statements must also disclose illiquid securities in the portfolio, the investment made in rated and unrated debt securities, non-performing assets (NPAs), etc.

There are so many options for mutual funds to choose from. How do I know which one is the best for me?

There is no one size fits all mutual fund scheme. The needs of each investor are different. The investor should analyze the investment objective, the risk appetite, and the investment horizon before making any decision. It is also prudent to read the offer document of the mutual fund scheme carefully. Before an investment, take a look at the past track record of the performance of the scheme or other schemes of the same mutual fund. You should also compare the performance with other schemes having similar investment objectives. In the case of debt-oriented mutual funds, the investor should also take into consideration the credit rating of the debt instruments.

If you are not confident about your investment decision, it would be wise to seek the guidance of an investment adviser.