Asset Allocation between Equity and Debt
Most investors invest in equity and debt as per their appropriate asset allocation. Equity has the potential to provide growth to the portfolio when stock markets are doing well. Similarly, debt provides stability to the portfolio when stock markets are falling.
What is a Debt Fund?
A debt fund collects money from investors and invests in fixed income securities on their behalf. The fixed-income securities for investment can include Government securities, corporate bonds, money market securities, commercial paper, etc. The tenure of these fixed income securities, the interest rate, the payment frequency, etc., are fixed. These details are specified at the time of purchasing these securities. The investors are allotted the debt fund units in proportion to their investments.
The net asset value (NAV) of the scheme moves up or down based on the value of the securities held in the scheme portfolio. An investor’s profit or loss depends on the movement of the NAV from the purchase price.
How does a Debt Fund Generate Income?
A debt fund generates income in two ways: interest and capital gains. It receives periodic interest on the fixed-income securities in the portfolio. Fixed income securities such as Government bonds pay interest on a half-yearly basis.
A debt fund also earns capital gains when the price of the securities it holds in its portfolio moves higher than the purchase price. Bond prices have an inverse relationship with market interest rates. When market interest rates move down, bond prices move up, and when market interest rates move up, bond prices move down. So, in a falling interest rate scenario, the bond prices move up, thus generating capital gains for the debt fund.
Debt Fund Types
The market regulator SEBI has categorised debt funds into 16 sub-categories. Let us look at some of these.
| Debt fund category | Scheme characteristics |
| Overnight fund | Invests in securities having a maturity of one day. |
| Liquid fund | Invests in debt & money market securities whose maturity is up to 91 days only |
| Money market fund | Invests in money market instruments having a maturity of up to one year |
| Duration funds (ultra-short, low, short, medium, medium to long, long) | Invests in debt and money market instruments based on Macaulay Duration (ranging between three months to more than seven years) of the portfolio. |
| Dynamic bond | Invests across duration |
| Corporate bond fund | Invests a minimum of 80% of its total assets in corporate bonds (highest rated instruments) |
| Credit risk fund | Invests a minimum of 65% of its total assets in corporate bonds (below highest rated instruments) |
| Banking and PSU fund | Invest a minimum of 80% of its total assets in debt instruments of banks, public sector undertakings, public financial institutions. |
| Gilt fund | Invests a minimum of 80% of its total assets in Government securities (across maturity). A gilt fund with a 10-year constant duration invests a minimum of 80% of its total assets in Government securities such that the Macaulay duration of the portfolio is equal to 10 years. |
| Floater fund | Invests a minimum of 65% of its total assets in floating rate instruments. |
Among the funds mentioned above, overnight funds carry the lowest interest rate risk and credit risk. Gilt funds carry the highest interest rate risk, and credit funds carry the highest credit risk.
Performance of Debt Funds
While there are many sub-categories in the debt mutual fund segment, it is not possible to cover the performance of all of them. In this article, we will focus only on the performance of the top five gilt funds.
| Scheme name | AUM (Rs. crores) | 1-year | 3-years | 5-years |
| IDFC Government Securities Fund | 1,466 | 2.80% | 10.37% | 8.31% |
| Edelweiss Government Securities Fund | 118 | 5.23% | 10.21% | 8.26% |
| Nippon India Gilt Securities Fund | 1,346 | 2.68% | 9.42% | 8.08% |
| Aditya Birla Sun Life Government Securities Fund | 1,035 | 3.98% | 9.42% | 7.82% |
| DSP Government Securities Fund | 431 | 3.50% | 10.13% | 7.79% |
Note: The returns are as of 19th Jan 2022. The returns are for direct plans with growth option. The one-year returns are absolute. The three and five-year returns are CAGR. The funds have been ranked based on five-year performance.
How to select a Debt Fund for Investment?
A debt fund can be selected for investment based on the purpose of investment, duration of investment, or risk profile of the investor.
i. Purpose of Investment:
If you are looking to build and manage an emergency fund, you can choose to invest in a liquid mutual fund.
ii. Duration ofIinvestment:
If your investment duration is less than one year, you can choose to invest from overnight funds, money market funds, ultra-short duration funds, low duration funds, short-duration funds, etc. If your investment duration is more than one year, you can choose to invest from medium duration funds, medium to long-duration funds, or long-duration funds.
iii. Risk profile of Investor:
If you have a conservative risk profile, you can choose to invest in a gilt fund. If you have a conservative to moderate risk profile, you can choose to invest in a banking and PSU fund or corporate bond fund. If you have an aggressive risk profile, you can choose to invest in a credit risk fund.
Taxation of Debt Mutual Funds
The taxation of debt funds depends on the investment time horizon for which they are held.
i. Short-term Capital Gain (STCG) Tax:
If you sell your debt mutual fund units before 36 months, the capital gain will be classified as short-term capital gain (STCG). The STCG will be added to your overall income and taxed based on your income slab.
ii. Long-term capital gain (LTCG) tax:
If you sell your debt mutual fund units after 36 months, the capital gain will be classified as long-term capital gain (LTCG). The LTCG will be taxed at 20% with indexation benefit or 10% without indexation benefit.
Now that you have a basic understanding of debt funds, you can go ahead and start investing! However, please do your own research as well before you do so!