5 things to consider when investing in debt funds

Debt funds are mutual funds that invest a sizable amount of their capital in fixed-income securities, including treasury bills, corporate bonds, government securities, and debentures.

The term “fixed-income securities” refers to all instruments with a predetermined maturity date and interest rate, which the buyer can earn on maturity. The returns are often unaffected by market movements. Debt securities are therefore viewed as low-risk investment options.

Here are 5 things to consider when investing in debt funds:

1. Yield to maturity

The yield to maturity of a debt fund is the anticipated return rate assuming that all of the securities in the portfolio are held until maturity. Suppose the portfolio remains constant until all of the holdings in the portfolio mature. In that case, the investor will gain 9% if the yield to maturity of the debt fund is 9%.

On the other hand, if the fund manager employs an aggressive portfolio management strategy, yield to maturity is not a trustworthy predictor of returns.

2. Change in interest rate

Changes in interest rates have a significant impact on debt mutual funds, particularly long-term plans.Bond prices rise when interest rates go down, which raises the NAVs of debt mutual fund schemes.

3. Know the credit rate

The AMC buys debt papers and bonds from corporations, governments, and quasi-governments in debt funds. Credit rating organisations rate debt securities based on the issuer’s creditworthiness and repayment capacity.

The best and least credit-risky fixed-income instruments are those rated AAA. A ‘C’ credit rating indicates that a security is likely to default.

However, this feeling of security comes with lower returns. Hence, as there is a little reduction in the credit quality, predicted returns will rise, but at high risk. Therefore, investors should examine the debt fund’s average credit quality to see whether it matches their level of risk tolerance.

4. Expense ratio

The expense ratio is a portion of the fund’s total assets representing the cost of fund management services. The ratio is the total cost of all expenses incurred during the debt fund scheme’s operation. Since debt funds have lower returns or upside potential than equity mutual funds, the expense ratio is more important.

A direct plan could be the best choice for investors with low-cost ratios. Investors can determine the returns from debt funds after considering the cost ratio.

5. Tax efficiency

Debt funds, unlike bank deposits, do not withhold taxes at source (TDS). You are responsible for paying taxes on the capital gains made after indexation if you redeem your investments after three years. You can change the value of your assets through indexation to reflect the current inflation rate. It is, therefore, more tax-efficient than bank deposits and other conventional saving methods.

Conclusion

Since NAVs are unpredictable, debt funds cannot guarantee returns like bank deposits. This is due to the inverse relationship between interest rates and bond prices. Debt funds, however, are significantly less erratic than equity funds. Short-term debt funds are less volatile than long-term debt funds, even within debt funds. As a result, investors seeking stable returns or consistent income couldfavour looking at short-term debt funds.