Choosing a debt fund? Here is what you need to know beforehand (2024)

One of the unfortunate yet common errors that amateur investors commit is directing all their funds into one kind of investment. The hallmark of a successful investor would ideally be a diversified portfolio. In a nutshell, this means that the investor will need to be exposed to multiple asset classes. One such major asset class apart from equity is debt. Debt is one of the most prominent markets that investors can place their funds to multiply their wealth. For those commencing their investment journey, debt funds are a crucial segment that should be a part of their portfolio. But before delving into the details of what to know before choosing a debt fund, one needs to understand what a debt fund is and how it works.

What is a debt fund?
Simply put, debt funds are mutual funds that invest the investors’ money in fixed-interest generating securities, including government and corporate bonds, debentures, and other money market instruments. Debt funds are also often considered safer as opposed to the volatility that the equity market brings since debt funds come with lower risk albeit lower returns. They come with varying maturity periods and can generate income either at the time of maturity or periodically.

Debt funds are one of the best investment options for investors with low risk tolerance since they aren’t as volatile as equity investments. However, investors, particularly those who are new to investing, often find themselves at a crossroads when choosing debt funds that are best suited to their portfolio, financial goals, and requirements. That said, here’s what one needs to know before investing in a debt fund.

Fluctuating interest rates
As mentioned earlier, debt funds are fixed investments, and fixed investment securities react inversely with the interest rates. This means that an increase in the interest rate will lower the returns on the debt fund and vice versa. Additionally, the longer the maturity period for the debt fund, the higher the risk of the interest rates fluctuating. However, investors might need to keep a long investment horizon to reap better returns/capital appreciation. While debt funds, too, are subject to the risk of interest rate fluctuations, they offer the investors flexibility in entry and exit from the fund.

Credit quality
As an investor, it’s essential to understand that debt fund holdings are categorized based on the credit ratings given by rating agencies – AAA, AA+, A1+, etc., and investors can choose funds based on this. For instance, the AAA credit rating means there is lower risk but higher-quality – best suited for conservative investors. On the other hand, debt funds that have a lower credit rating can come with higher stakes. It’s best to opt for a fund that has a majority of high-quality bonds but also to do thorough research before considering an investment in funds that have a lower rating.

Long-term taxation benefits
The duration for which a fund is held impact the taxation benefits the investor receives. Debt funds that are held for less than a year can incur a short-term capital gains tax for the investor. However, debt funds held for more than a year will have a long-term capital gains tax of 20% and include indexation benefits.

Expense ratio
Considering the expense ratio prior to investing in a debt fund is imperative. If a debt fund yields 10% returns, the investor will not receive the entire amount since the AMC (Asset Management Company) deducts charges such as operating fees and other overhead charges. These are the expense ratio of the mutual fund that investors will need to look out for before choosing a debt fund. It’s best to opt for a fund where the expense ratio is minimal.

Diversifying your portfolio with venture debt
As mentioned earlier, diversification is a crucial aspect in the journey of becoming a successful investor. And there is one segment that must be considered, especially if the investor plans on becoming an angel in the future – venture debt fund. To put it simply, a venture debt fund invests in startups alongside the equity investors, thereby enabling them to meet their working capital requirements. However, in lieu of the debt, venture debt funds can gain a share of the equity stake in the company. Venture debt facilitates profitability and growth and is also more affordable than equity. Besides, venture debt also doesn’t dilute the founders’ stake in the startup, and can offer high returns.

Summing up
We have often heard ‘Mutual funds are subject to market risks’ on several announcements and advertisem*nts. Among the mutual funds available in the market, debt funds are relatively one of the safest with predictable returns, increased liquidity, and convenience, making them one of the most sought-after investment instruments in the market, especially by investors who have a low risk appetite. The only thing to remember would be to do thorough homework before beginning your investment journey and check the best-performing funds to gain maximum returns.

The writer is Co-Founder & CEO of Mumbai Angels.

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