A Complete Guide to Investing in Debt Funds: Understanding the Basics, Risks, and Returns

31 Oct 2023



A debt fund is a mutual fund scheme that generally invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that seem to offer capital appreciation.

What Are Debt Funds and How Do They Work?

Debt funds invest in listed or unlisted debt instruments, such as corporate and government bonds, at a specific price and later sell them and receive the realized value. The difference between the purchase cost and selling price determines the appreciation or depreciation of the fund's net asset value (NAV). These funds also receive periodic interest payments from the underlying debt instruments they invest in. Debt funds may earn regular interest, can be similar to bank fixed deposits that accumulate interest over time. Consequently, the NAV of a debt scheme can be influenced by the interest rates of its underlying assets as well as any changes in the credit rating of its holdings.

An increase in interest rates can result in a potential decline in the value of current debt instruments. Changes in the interest rates can lead to fluctuations in the value of the instruments held by fund.

Types of Debt Schemes: An Overview at some of the scheme type in the Debt funds category*:

Liquid Funds: Characteristics and features

For a high risk averse investor, they can consider opting for a liquid scheme. For retail investors, traditional investment mode such as a savings bank account serves as a comparable option to a liquid scheme. These schemes may be ideal for individuals who wish to temporarily park their funds for short durations, typically up to 30 days. They may offer high liquidity and minimal volatility. While planning for investments, Liquid funds can be seen as an option for short term parking of funds, rather than for a longer duration.

Ultra-short Duration funds:

Ultra-short duration funds, on the other hand, hold securities with slightly longer tenors compared to liquid funds. These funds can be suitable for short term investment purpose. These can be ideal for investors looking for an investment horizon between 3-6 months.

Short- Duration Funds: Features

Short Duration Funds are short term debt schemes investing in instruments with Macaulay duration between1 year- 3 years. These funds mainly invest in Debt and money market instruments, such that the Macaulay duration of the portfolio is between 1 year to 3 years. The investment time frame of these funds is longer than those of Liquid Funds.

Long-Duration Funds: Features and Suitability

Long-duration funds refer to a category of Debt Mutual Fund schemes that primarily allocate their investments in instruments with Macaulay duration greater than 7 years.  These funds mainly invest in debt and money market instruments such that the Macaulay duration of the portfolio is greater than 7 years.  These funds can be ideal for investors looking for a longer time frame for their investments in debt funds.

Gilt Funds: Features

A gilt fund generally invests in government issued bonds, issuances   by the Central and State Governments of India, serving as a means of borrowing money. These bonds are issued when the government, either at the central or state level, needs funds for infrastructure development due to a shortage of liquidity.

Also referred to as G-secs, in India, a government bond g-represents an agreement between the issuing entity and the investor. The issuer assures the investor of earning interest on the bond's face value, and also commits to repaying the principal amount on a specified date.

Government bonds in India belong to the wider classification of government securities known as G-Sec. These bonds serve as long-term investment instruments and have durations ranging from 5 to 40 years. They are issued by both the Central and State governments of India. When State Governments issue these bonds, they are commonly referred to as State Development Loans (SDLs).

Gilt Funds require to have minimum investment of 80% of total assets (across maturity)  in G-secs. These can be ideal for investors with an investment horizon of 2 to 3 years with investments predominantly in government securities.

Risks and Returns of Debt Funds: Understanding the Key Factors

Interest Rate Risk: Causes and Likely effects on Debt Funds Performance

Interest rate risk refers to the potential for an investment's value to fluctuate due to changes in interest rates. This risk has a more direct impact on the value of bonds and debt instruments compared to stocks. When interest rates decrease, the value of these instruments tends to increase, and vice versa.

  Investors may be familiar with debentures, typically purchase and hold these bonds until they reach maturity. Upon maturity, investors receive the agreed-upon maturity amount as per the bond agreement, assuming the issuing company fulfils its commitment and does not default.

On the other hand, if an investor decides to sell the bond in the secondary market, they would have to transact at the prevailing market price. This price is influenced by various factors, with one of the primary factors being the fluctuation in interest rates within the economy. The relationship between interest rates and bond prices is inverse, meaning that when interest rates change, bond prices move in the opposite direction.

Credit Risk: Evaluating the Creditworthiness of Debt Fund’s Securities

Fixed income securities, including debt and money market securities, are exposed to the possibility that the issuer may be unable to fulfil its obligations to make interest and principal payments on its debt. The Investment Manager will strive to mitigate credit risk by conducting their own analysis of creditworthiness of the issuer.

The different Debt   schemes can invest in various types of securities mentioned in the Scheme Information Document (“SID”), each carrying different levels of credit risk. Consequently, the risk associated with the Scheme may increase or decrease depending on the investment choices made. For example, corporate bonds entail a higher degree of risk compared to Government securities. Additionally, within the realm of corporate bonds, those rated AAA are relatively less risky than bonds rated AA.

Credit risk refers to the likelihood that the counterparty will fail to fulfil its obligations

Liquidity Risk: Managing the Impact of Market Volatility

If the securities in the mutual fund scheme’s portfolio have infrequent trading activity or lower demand, the fund manager might face the possibility of selling them at a loss if the intention is to sell before their maturity.

Few Factors to Consider When Investing in Debt Funds: How to Choose the suitable Fund

Credit Quality: Understanding the Importance of Credit Ratings

The credit quality of mutual fund schemes is generally the credit rating associated with the instruments that form part of the scheme’s portfolio, that provides insights into the creditworthiness of bonds or the  portfolio, serving as an indicator of their financial reliability.

Expense Ratios: Evaluating the Costs of Investing in Debt Funds

When you invest in debt funds, it is crucial to consider this aspect. The expense ratio represents a percentage of the fund's total assets that is charged as a fee for fund management services. Generally, given that returns in debt funds tend to be modest, a high expense ratio can impact your earnings.

Conclusion: Why Debt Funds Can Be a Valuable Addition to Your Investment Portfolio

While planning for those financial goals, Debt funds can be considered to invest now.

Additionally, allocating a portion of your funds to debt funds like liquid funds can serve as an emergency fund, serving as a financial buffer to address unexpected financial emergencies. With their ability to potentially generate favourable market-linked returns while maintaining reasonable liquidity, debt funds have become a vital component of an investor's asset allocation strategy. Although they are exposed to risks such as interest, credit, and liquidity, investors have the flexibility to select from a variety of debt funds that align with their risk-return preferences and investment objectives.

For informed investment selections, one can seek the advice of financial professionals or go online for market and fund updates.

Frequently Asked Questions (FAQs) About Investing in Debt Funds

How do interest rate risk, credit risk, and liquidity risk affect debt fund performance?

Despite the general perception of debt funds being safer due to their primary investments in fixed income securities, it is important to acknowledge the existence of risks associated with investing in debt funds. Therefore, investors should exercise caution and make informed decisions when considering investments in debt funds.

While credit risk and interest rate risk are the two main risks associated with debt funds, recent credit events have brought attention to another significant risk: liquidity risk. Investors should carefully read and understand the risk factors associated with the debt investments, as provided for in their Scheme documents.

What are the different types of debt funds?

There are various types of debt funds, categorized based on the types of securities they invest in, including liquid funds, dynamic funds, and gilt funds, amongst others.

What is the tax treatment of debt fund investments?

Starting April 1, 2023, there have been alterations to the taxation regulations concerning debt mutual fund schemes. Under the recently implemented tax rules, "specified debt mutual fund schemes" with equity investments comprising less than 35% of their assets under management will no longer qualify for indexation benefits. Investors should consult their tax advisor before making any investment decision.

How can I redeem my investments in a debt fund?

To initiate the redemption process, can access the 'Online Transaction' page of the preferred Mutual Fund. Sign in by providing your Folio Number and/or PAN, then choose the desired Scheme and specify either the number of units or the amount you intend to redeem. Finally, confirm your transaction to proceed.  Investors should carefully read and understand the redemption related details as provided for in the respective Scheme information documents.



* Categories as per para 2.6 of   SEBI Master circular No. SEBI/HO/IMD/IMD-PoD-1/P/CIR/2023/74 dated May 19, 2023.

The information contained in this (document) is extracted from different public sources/ Kotak Mahindra Asset Management Co Ltd (“KMAMC”) internal research. All reasonable care has been taken to ensure that the information contained herein is not misleading or untrue at the time of publication. This is for the information of the person to whom it is provided without any liability whatsoever on the part of KMAMC or any associated companies or any employee thereof.

These materials are not intended for distribution to or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. The distribution of this document in certain jurisdictions may be restricted or totally prohibited and accordingly, persons who come into possession of this document are required to inform themselves about, and to observe, any such restrictions. Investors may consult their financial advisors and/or tax advisors before making any investment decisions. Investors should make any investment decision only as per their risk appetite. Investors should read the Scheme information documents carefully before making any investment decision.  Kotak Mutual Fund/ Kotak Mahindra Asset Management Company Limited is not guaranteeing or promising or forecasting any future returns/performances.


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© Kotak Mutual Fund.2023
Mutual fund investments are subject to market risks, read all scheme related documents carefully.
© Kotak Mutual Fund.2023
Mutual fund investments are subject to market risks, read all scheme related documents carefully.
© Kotak Mutual Fund.2023
Mutual fund investments are subject to market risks, read all scheme related documents carefully.