Introduction You interact with money in 3 ways, namely - Earn, Spend, Invest. How you earn money is dependent upon your profession and capabilities. How you spend money depends upon your needs, inclinations and your budget. But how you invest money depends upon your awareness of various investment options available around you, and the financial advice available to you. Investing without proper assessment of every investment avenue can land you either in a scenario where you earn very less return, or it can land you in a scenario where you end up loosing all your capital. Both the situations are undesirable and can be avoided, afterall it is your hard earned money and you need to give it time. This writeup focuses on one investment option which is not much talked about, but has many advantages and gives decent post tax returns. The investment option being talked about here is Debt Funds.
What are debt funds ? Debt funds are a kind of Mutual funds. A debt fund collects money from a large number of investors, makes a pool of money, and gives this money as debt to the entities which need money for growth and other needs. This debt is extended to the borrowers by means of instruments called securities which are issued by companies needing debt and government of India. These securities are also called Corporate bonds, debt securities, treasury bills and money market instruments. The debt earns interest as per agreed rates. Generally, interest rate earned depends upon the credit rating of the borrowers. There are independent rating agencies (CARE, CRISIL, FITCH, ICRA) which study the corporates in terms of their financials, profitability, business, sector, competition, past track record and several other factors, and after extensive study come out with rating. If rating is good the interest earned will be less, and if rating is poor, interest earned will be higher. Fund houses incorporate a mix of high and low rated securities to ensure decent returns and also manage the risk profile of the fund.
Debt Funds Vs. FD It is important to study the debt funds vis a vis FD as investment option because debt funds come close to FD in terms of risk profile. In FD we deposit money with the banks for various tenures and earn an interest which could range about 6-8% depending upon the bank and the duration of FD, while in debt funds we park our money with Mutual fund companies, and expect them to manage our investments and lend the money further. In FD our money is considered almost 100% safe because irrespective of whether bank has been able to recover the money from borrowers or not, the investor in FD will get fixed predefined rate of return, so to put it technically, the entire risk lies with the bank, and the investor gets the return. In case of Debt fund, the mutual fund institution invests on behalf of a group of small investors and charges an administration fee. The key difference comes here. Suppose a debt mutual fund extends credit to a corporate at a fixed interest rate for 2 years, and after 2 years that corporate goes bankrupt and unable to repay the debt to the mutual fund house, then that will be a loss of capital and that loss will be passed on to all the investors in that particular debt fund meaning the fund house will not bear that loss and that loss will have to be borne by the investor. In effect, the debt funds carry a risk level which is higher than the risk in FD.
Then why invest in Debt funds Why to invest in debt funds if they carry a higher risk? Well, the reasons are many. First of all if you fall in 30% tax bracket, then the effective post tax return on FD comes anywhere between 4.2% to 5.5% which is abysmally low and even lower than the rate of inflation, meaning that what you can buy with your money today, the same amout of money will not suffice to buy same thing after say 2 years, so in effect there is no real appreciation of your money and infact in a way you are loosing the buying power. Debt funds offer a rate of return anywhere ranging between 7%-10% and may in some cases go beyond 10% as well. But the real benefit lies in the way debt funds are treated for taxation. The gains in investment via debt funds are categorized as Capital gains. If your investment in debt funds exceeds 3 years, then they are called long term capital gains (LTCG), gains on investment less than 3 years are called short term capital gains (STCG). If debt fund units are sold before 3 years, then they attract taxation on STCG as per the tax bracket of investor. If debt fund units are sold after 3 years, they attract tax on LTCG which is 20.6% with indexation. That means that long term capital gains are indexed with inflation and tax is applicable only on the portion of return above inflation rate which is around 6-8% in current scenario. As a result the effective tax on entire gain in investment amounts to very low levels. Thus, the debt funds offer effective post tax returns of 7-10% if the units are held for a period greater than 3 years and beat the post tax rate of return on FDs.
Who should invest in debt funds Debt funds carry much lesser volatility as compared to equity mutual funds, and offer stable returns. But they carry a certain amount of risk because there exists a possibility of default by the corporates to which debt is given by the fund house. Debt mutual fund house invests the money collected in a number of fixed return securities, so that even if one of them goes bad, the entire investment is never at risk. This strategy is called diversification. Nevertheless, since there is a risk involved albeit of a lesser degree as compared to equity mutual funds, debt funds are suitable to investors with little risk appetite. Secondly, investors which can lock in their funds for atleast 3 years should involve debt funds in their portfolio. Because if the money is withdrawn before 3 years, the advantages of debt fund go away as the capital gain is taxed fully as per the tax bracket, and the fund houses also impose a penalty on withdrawals before 3 years which could range from 1% to 3% depending upon the terms & conditions of different debt fund offerings. FDs are more liquid option as compared to debt because the effective return doesn't change much in case of premature withdrawal in FDs. Return on FD is taxed every year, but the return on debt fund is taxed only at the time of sale of units. So the key point is to invest for minimum 3 years in debt funds, to realize maximum benefits.
Conclusion Debt funds are an attractive investment options for conservative investors with little risk appetite. Minimum time horizon should be 3 years if one considers debt funds as an investment option. Debt funds are a must have in one's portfolio, the extent can vary as per the financial needs and risk appetite of investors. Debt fund valuations are affected by the changes in macroeconomic environment primarily the interest rates, so investment in debt funds should not be done in one go, instead small amounts should be invested in debt funds at regular intervals, either monthly or quarterly. Overall, debt funds score on multiple counts over the FDs, and should be actively considered.
A very useful article for the debt investors. Debt fund is a neglected area of investment compared to equity mutual funds or bank fixed deposits. However, the debt mutual funds show much less volatility than equity mutual funds, but gives much better returns than bank fixed deposits.
I have already written an article on debt mutual funds: Debt mutual funds - types and investment philosophies