Understanding Debt Mutual Fund schemes: Meaning and How They Work

Mutual funds have become a popular investment vehicle for many Indian investors, offering a range of options to suit different financial goals and risk appetites. (You are recommended to seek advice from financial advisor before you take any/refrain from any action). Among these, debt schemes stand out as a preferred choice for conservative investors seeking stability and predictable returns. This blog aims to provide a comprehensive understanding of debt schemes, their workings, types, benefits, and associated risks.

Debt scheme are a type of mutual fund scheme that primarily invests in fixed-income securities such as government securities, corporate bonds, treasury bills, and commercial papers. These schemes are designed to provide regular income with relatively lower risk compared to equity schemes, making them an attractive option for risk-averse investors.

Debt schemes invest in a variety of fixed-income instruments, which are essentially loans given to entities like the government or corporations. These entities issue bonds or other debt instruments to raise capital, promising to pay back the principal amount along with interest at a specified rate. By investing in these instruments, debt schemes generate income for their investors through interest payments.

What is a Debt Mutual fund scheme?

A debt scheme is a type of mutual fund scheme that pools money from multiple investors to invest in a diversified portfolio of fixed-income securities. The primary objective of debt schemes is to generate regular income while preserving the capital. Unlike equity schemes, which invest in stocks and are subject to market volatility, debt schemes are considered more stable as they invest in instruments with fixed returns.

Debt schemes are managed by professional fund managers who select securities based on factors such as interest rates, credit ratings, and maturity periods. The performance of debt schemes is influenced by the interest rate movements in the economy. When interest rates fall, the value of existing bonds with higher interest rates increases, leading to better returns for debt scheme investors.

How Do Debt schemes Work?

Debt schemes operate by investing in a mix of fixed-income securities with varying maturities and credit ratings. The fund manager's role is crucial in selecting the right mix of securities to optimize returns while managing risks. Here’s a simplified explanation of how debt schemes work:

1. Pooling of Funds: Investors contribute money to the debt schemes, which is pooled together to create a substantial investment corpus.
2. Investment in Securities: The fund manager invests this corpus in a diversified portfolio of fixed-income securities such as government bonds, corporate bonds, and money market instruments.
3. Interest Income: The securities in the portfolio generate interest income, which is distributed to the investors.
4. Capital Gains: If the fund manager sells a security at a higher price than its purchase price, the resulting capital gain is added to the scheme’s returns.
5. NAV Calculation: The Net Asset Value (NAV) of the debt scheme is calculated daily based on the market value of the securities in the portfolio. Investors can buy or sell units of the scheme at the prevailing NAV.

Types of Debt schemes

Debt schemes come in various types, each catering to different investment horizons and risk profiles. Here are some common types of debt schemes:

1. Liquid Fund: These fund invest in short-term money market instruments with maturities of up to 91 days. They offer high liquidity and are suitable for parking surplus funds for short durations.
2. Short-Duration Funds: These fund invest in securities with maturities ranging from one to three years. They are ideal for investors with a short to medium-term investment horizon.
3. Gilt Fund: These fund invest in government securities with minimum investment of 80% of total assets, which are considered to have minimal credit risk. They are suitable for risk-averse investors looking for safe investments.
4. Credit Risk Fund: These fund invest in lower-rated corporate bonds, offering relatively better returns but with increased credit risk. They are suitable for investors willing to take on more risk for relatively better returns.
5. Overnight Fund: An open ended debt scheme investing in overnight securities. Investment in overnight securities having maturity of 1 day.

(For further information on other types of debt schemes, you may refer the below mentioned link: https://www.amfiindia.com/investor-corner/knowledge-center/SEBI-categorization-of-mutual-fund-schemes.html)

Benefits of Investing in Debt schemes

Investing in debt schemes offers several advantages, making them a popular choice among conservative investors:

1. Relatively stable Returns: Debt schemes provide relatively stable returns compared to equity schemes, making them suitable for risk-averse investors.
2. Liquidity: Debt schemes offer high liquidity, allowing investors to redeem their units at any time without significant penalties.
3. Tax Efficiency: Long-term capital gains from debt schemes are taxed at a lower rate with indexation benefits.

Risks Associated with Debt schemes

While debt schemes are considered safer than equity schemes, they are not entirely risk-free. Here are some risks associated with debt schemes:

1. Interest Rate Risk: The value of debt securities is inversely related to interest rates. When interest rates rise, the value of existing bonds falls, leading to a decline in the NAV of debt schemes.
2. Credit Risk: Debt schemes offer high liquidity, allowing investors to redeem their units at any time without significant penalties.
3. Inflation Risk: The returns from debt funds may not always keep pace with inflation, leading to a reduction in the real value of the investment over time.

How to Invest in Debt schemes

Investing in debt schemes is a straightforward process. Here are the steps to get started:

1. Assess Your Financial Goals: Determine your investment horizon, risk appetite, and financial goals before choosing a debt scheme.
2. Select the Suitable Type of Debt scheme: Based on your goals and risk profile, select the appropriate type of debt fund.
3. Choose a Fund House: Research and select a reputable fund house with a good track record.
4. Complete KYC Formalities: Complete the Know Your Customer (KYC) formalities, which are mandatory for investing in mutual funds.
5. Invest Online or Offline: You can invest in debt schemes online through the fund house’s website or offline through a financial advisor or distributor.

For better understanding, you may seek advice from your financial advisor.

Conclusion

Debt schemes play a crucial role in a diversified investment portfolio, offering stability and predictable returns. They are an excellent option for conservative investors looking to preserve capital while earning regular income. By understanding the different types of debt schemes, their benefits, and associated risks, investors can make informed decisions and achieve their financial goals.

Additional links

What is a Mutual Fund? - Beginner's Guide to Investing

AMFI – Introduction to Mutual Funds

Everything you need to know about SIP

What are Debt Funds?

SEBI – Categorization of Mutual Fund Schemes

What are the different types of Debt Funds?

Let’s Learn How to Invest in Securities Market