Mutual fund investment gathers money from a large number of small investors and creates a pool of money. This pool is then divided for investment instruments.
Mutual fund companies generally invest their fund in fixed income or fixed interest generating opportunities like money market instruments, corporate bonds, treasury bills, government securities, and commercial papers. It is more-safer option to generate income of interest on fixed deposit rather than high returns on the equity market.
How does a debt mutual fund
Unlike Equity mutual fund scheme that seeks to gain capital appreciation through investment in equity stocks of companies, debt mutual funds attempt to gain stable and low-risk returns that are usually better than fixed deposits. Though this type of return is quite low, risk-averse investors prefer this investment, as it does not involve a great deal of risk.
The choice of a fund in this type of investment depends on its credit rating. The credit rating of the debt instrument indicates the likelihood of the instrument to honor it’s interest payments and the eventual principal at maturity. The higher the rating of the debt instrument chosen, the lesser the risk that the mutual fund may not receive all its dues.
Check here – Difference between Equity and Mutual Funds
What are the types of mutual funds
- Income funds: – These funds provide a stable rate of returns in all market conditions through portfolio management. While it is a debt fund, income funds also run the risk of generating negative returns due to many situations like a drastic drop in interest rates, drop in underlying bond prices or the fund manager may pick up a lower-rated instrument for high returns.
- Dynamic bond funds: – These funds seek to maximize the return by switching the investment portfolio depending upon the market conditions and fluctuations.
- Liquid funds: – The entire focuses of these funds are focused on maintaining a high degree of liquidity (ie convertibility to cash/cash value) in the investment. Securities and investment in which such liquid funds are put have a maximum maturity period of 91 days. Usually, liquid funds are invested in highly rated instruments and securities. These funds are suited to those investors who have surplus funds to park in income yielding investment. This is because the rates of return are higher than the savings bank rate and have a similar level of liquidity.
- Credit opportunity funds: – They are a bit riskier type of debt mutual funds as they undertake calculated risk like investment in lower rated instruments to generate potentially higher returns Credit opportunity fund manager invests in instruments rated under even “AA”, anticipating that it will rise to a higher rating over a time, thus increasing in its value.
- Short term and ultra-short term:- They are popular among new investors who want a short term investment with minimal risk exposure. The investment instruments under this type have maturity from 1 year to 3 years.
- Gilt funds:- These funds usually include government-issued securities which carry a very low level of risk and a very high rating. The low risk-taking factor in such funds is compensated by the security rating.
- Fixed Maturity plans:- In this plan, the investment is done once during the initial offer period, after which further investment cannot be made in this scheme. These schemes have a mandatory lock-in period that varies depending upon the scheme chosen. They are distinguished from fixed deposits in the way that it does not guarantee the returns, but they do generate positive returns which are most likely higher than the Bank’s fixed deposit. You may or should invest in debt funds if.
- If you have a surplus fund to park for a smaller period and able to take a little bit of risk for a proportionally high rate of return better than saving account or fixed deposit of bank.
- If you do not want to place your money in high-risk areas.
- You prefer stable and small returns over the large capital appreciation.
- You are not happy with the current rate of return in SB A/c.
- You wish to supplement your current income level, for example, your salary does not meet the demands of your lifestyle and you need a certain amount of additional income every month.
Key features in Mutual debt fund investments
- Investment Horizon:- This refers to the time in which you wish to achieve your financial goals through investment. Debt mutual funds have options which are almost fit to any investment horizon. They may be liquid funds 3-12 months, bond funds for 24-36 months, and dynamic bond funds from 24m-60m.
- Returns: – This is the primary factor upon which investors pick their schemes. Though the debt fund schemes are primarily aimed at reducing the risk and giving regular returns, nothing in the mutual fund industry is guaranteed.
- Tax liability: – All mutual funds are subjected to tax provisions. The capital appreciation is subjected to capital gain tax. Short term capital gain (STCG) is applicable when the funds are held up to 3 years and long term capital gain tax (LTCG) is applicable in case they are held for more than 3 years.
- Risk: – This is the main attractive feature of debt mutual fund. Low risk is the primary benefit of this type of investment. Even so, debt schemes are not totally risk-free. There are mainly two types of risks. One is credit risk when fund manager invests in low rated securities, exposing the returns to a high probability of default. Second is the interest risk wherein the increase in interest rates would drastically lower the value of related bonds.