While equity mutual funds are most suitable for any long-term goal-based investment, debt funds are ideal for risk-averse investors. Retail investors are gradually move away from traditional investments, such as fixed deposits, to seek higher yields which are tax-efficient.
If the investment horizon is less than five years and the investor is not very comfortable with the volatility in the markets, then he should choose debt funds. These funds invest in various fixed-return instruments. However, there are some aspects that buyers must keep in mind while investing in a debt fund.
Debt funds give better returns than bank fixed deposits and are as liquid as any bank fixed deposits. Typically, corporate and high net worth individuals invest in debt funds. Mutual funds have been promoting debt schemes as an investment option for retail investors. There are attractive opportunities in debt schemes for retail investors, starting from overnight investment in liquid funds to duration debt products like, gilt funds, income fund and dynamic bond funds.
Liquid debt funds are ideal for those with an investment horizon of less than a month and ideally should be used to park money instead of a savings bank account. Ultra-short term funds investments are for less than 90 days and can be compared with short-term fixed deposits. Short-term debts funds are ideal for those with an investment horizon of 12 months. The tenure of the debt fund is very important because due to the longer period, there is additional risk and higher exposure to interest rate fluctuation. As the value of bonds is inversely proportional to the interest rate, a rise in the interest rate will see a fall in the price of bonds and vice-versa. So, a bond with shorter duration has less chance of fluctuation in the interest rate as compared with long term bonds.
Analysts say investors must focus on the risk appetite and return expectation to decide on the right tenure of debt fund. It is also pertinent to look at interest rates before investing in a debt fund. Salaried individuals should look at debt funds with low risk. In fact, liquid fund schemes of mutual funds are ideal for deploying surplus money for a short period of time — even overnight — without losing any liquidity. The money is invested in quality paper with adequate liquidity in the market. There is no exit load and investors can redeem whenever they want. Ultra short-term funds also provide similar benefits to investors for short-term investments.
At the time of investing in debt funds, investors must analyse the credit rating of the bonds in which the fund house invests. While debt funds are not rated, their safety can be analysed from the portfolio they invest in. Fund managers may sometimes take higher position in bonds with lower rating for higher returns.
However, at the time of redemption, such bonds may lack liquidity and investors may not be able to exit the fund. A debt fund with a large corpus will mean greater flexibility to diversify into various debt instruments.
At the time of redemption, large funds will never have to worry about exiting the investments but small fund will crash because of high redemption pressure as was seen in 2008. Investors should focus on debt funds that have higher asset under management.
While debt funds have given 8-10% returns in the past, returns are not guaranteed. Some debt funds fluctuate more because of changes in interest rate and investors must look at the past performance of the fund house with respect to various interest rate in different period before investing in debt funds. Such an analysis would reflect the performance of the debt fund under different scenarios and, based on that, investors must decide on the amount and duration of investment. In fact, most debt funds show good return when the interest rate moves down, but only good funds can perform well when the interest rate starts rising.
For taxation, from last year’s budget, the period of holding for debt mutual funds to qualify as a long term capital asset was increased from one year to three years.
Investors are taxed at a flat rate of 20% after indexation and, if debt funds are liquidated within a period of three years, the gain will be added to the total income and taxed at the applicable slab rate.
If the debt fund investor puts money in the fund in March of year one and sells in April of year three, he can claim indexation benefit. This will bring down his tax liability considerably and capital gains can also be set-off against the short-term and long-term capital losses suffered in other investments. So, debt mutual funds are better than bank fixed deposit because of indexation benefits.
* The period of holding for debt mutual funds to qualify as a long term capital asset has been increased from one year to three years
* Investors are taxed at a flat rate of 20% after indexation and, if debt funds are liquidated within a period of three years, the gain will be added to the total income and taxed at the applicable slab rate
* If a debt fund investor puts money in the fund in March of year one and sells in April of year three, he can claim indexation benefit
* This will bring down his tax liability considerably and capital gains can also be set off against short-term and long-term capital losses suffered in other investments