Debt funds - A popular alternative to traditional investment products
Debt mutual funds have emerged as an apt alternative to traditional investment options, such as bank fixed deposits, thanks to their ability to give mark-to-market (MTM) returns and indexation benefit for an investment horizon of over three years as per the current tax laws.
Debt funds – reasons for the rise in popularity
Debt funds, unlike traditional bank deposits, provide investors with the opportunity to generate market-linked returns by professional investment. While fixed deposits generally aim to provide guaranteed returns and safety to capital, subject to the applicable terms and conditions1 , debt mutual funds, at a slightly higher risk, provide investors with an opportunity to invest across the debt spectrum based on their risk-return profile and investment horizon.
Further, on the tax front, interest from bank deposits is taxed as per the applicable tax slab of the investor, while for debt mutual funds, investment for a period of less than or equal to three years is subjected to short-term capital gains tax (STCG) and hence is taxed as per applicable tax slabs, and investment for a holding period of more than three years, is subject to long term capital gain tax (LTCG) and is taxed at 20% with indexation. The latter is quite beneficial for investors with more than three years of investment horizon, as it reduces the tax incidence
1Subject to maximum of Rs. 1 lakh by the Deposit Insurance and Credit Guarantee Corporation (DICGC), in terms of applicable regulations and other conditions.
A plethora of positives
Options within debt funds to meet all short- to medium-term goals
Additionally, debt funds offer a wide variety of choice; there is something for every investor profile. Choice of funds is based on personal criteria (investment horizon, risk profile and return expectations), credit profile and the underlying interest rate scenario.
- For short-term goals and low risk appetite
Investors with a low risk appetite aiming to build an emergency fund or having short-term goals, such as children’s tuition fees and settlement of one-time bills, can invest in liquid funds instead of a savings account as the former has the potential to generate better returns at reasonable liquidity.
Investors with a low risk-bearing capacity and short-term horizon (from a day to a week) can choose overnight funds. Investors with a slightly higher risk-bearing capacity can consider investing in ultra short-term funds and low duration funds. Note, short duration funds typically do well in a rising interest rate scenario and they are less sensitive to interest rate changes.
- For medium- to long-term goals and ability to bear moderate to high risk
There are short to medium duration funds with an investment horizon of 1 to 4 years. Further for investors with a high-risk appetite intending to invest for a medium to long term, debt funds like gilt funds, dynamic and long duration funds etc. with investment horizon of 4 years and above are available.
Meanwhile, investors with the ability to take risk or the affinity to invest in corporate bonds can look at credit opportunity and corporate bond funds / banking and PSU funds. A credit risk fund invests minimum 65% of its assets in corporate bonds which shall not be highest rated instruments, while a corporate bond fund invests minimum 80% in highest rated corporate bonds.
In addition, investors can consider fixed monthly plans (FMPs), which resonate with bank deposits. FMPs follow a buy-and-hold strategy which can help investors lock-in higher yields for the entire investment period. FMPs are close-ended debt funds with varying maturity tenures starting from three months to five years. Investors can only invest in or enter at the time of a new fund offer (NFO) period. Investors wishing to exit may do so, through the stock exchange where the FMP is listed. Redemption of the units of the FMPs is not allowed prior to the maturity of FMP. FMPs can generate higher tax-adjusted returns because of the benefit of indexation (adjusting gains after considering inflation) for a holding period of more than three years.
Evaluate underlying risk factors before investment
While debt funds offer a good opportunity to investors with a low risk profile, they do come with some risks. That notwithstanding, investors should evaluate all schemes based on the underlying risk factors and map them onto their risk-return profile and investment horizon.
Chart: Important risks related to debt funds
Apart from the above, certain other risks to which the debt mutual funds are exposed to are reinvestment risk, regulatory risk, currency risks, risk associate with investment in derivatives, foreign instruments, etc, depending on the investment objective and the strategy of the fund. Investors shall always refer to the Scheme Information Document and Key Information Memorandum carefully to understand the detailed risk factors associated with the particular mutual fund schemes.
Any comparison mentioned in this material is for general information only and not intended to be relied upon as investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Information and content herein has been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. Recipient are advised to seek independent professional advice before making any investments. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. SBI Mutual Fund / SBI Funds Management Private Limited is not guaranteeing or promising or forecasting any returns.
In view of the individual nature of the financial or tax consequences, each investor is advised to consult his/her own financial/tax consultant with respect to specific tax implications arising out of their participation in investments. The tax rates are as per current tax laws and are subject to change.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.