Rajesh Giridhar, a 23-year-old engineering graduate, has just stepped foot in the corporate world by bagging a job. Excited about getting his first-ever salary, Rajesh plans to buy the adventure bike he always wanted. But the problem is, Rajesh’s monthly income isn’t sufficient as he has to take care of monthly expenses like house rent, electricity bill, phone bill, food, etc. But there is one investment option Rajesh can consider, and that is investing some amount of his monthly income in debt funds. Rajesh needs to first cut down on his unnecessary expenditure so that he has enough money to regularly invest in debt funds. This way, he will not just be saving every month, this money invested in debt funds has the potential to grow and might help Rajesh seek some capital appreciation. Also, since debt funds are a lot less risky than mutual funds, Rajesh needn’t worry about losing out on his hard-earned money and can continue to save and hope that he is able to buy that adventure bike soon.
So if you are someone who too doesn’t want to take too much risk with their investments just like Rajesh, but want to improve their existing financial situation, you can consider investing in debt funds. But what exactly are debt funds? Are there more than one type of debt funds? Which debt fund is suitable for me? Shall I invest for short term or long term? If you too are asking these questions, read further:
What are debt funds?
While equity mutual funds invest in shares of publicly listed companies, debt funds invest in fixed income securities issued by the government and companies. These fixed-income securities generally include corporate bonds, government securities, government bonds, treasury bills, money market instruments, and other such debt securities. Debt funds are less risky than investing in equity mutual funds and have the potential to offer better returns as compared to traditional saving products.
Benefits of investing in debt funds
Investing in debt funds has its own merits. Here are some of the advantages debt fund investments hold:
- Meeting your short-term goals: We all have short-term goals like paying off the child’s school fees or having a contingency fund or even buying a gift for your loved ones. There is a range of debt funds basis the investment horizon that you may have to achieve your short-term goals from 3 months to 3 years.
- Liquidity: Debt Funds offer a high amount of liquidity without being penalized on withdrawals. You can withdraw the required amount and continue to stay invested on the balance amount.
- Tax benefits: If you stay invested in Debt Funds for more than 3 years, the gains that you make will only be taxed at 20 %( plus applicable surcharge and cess) (even if you are in a higher bracket). What’s more! It will only be taxed on profits made over and above the inflation. For example: If you earn profits by 10% on the debt fund and inflation (measured by Cost of inflation index) increases by 7% in the same period, you pay 20% (plus applicable surcharge and cess) tax only on 3% (10%-7%), which is 0.6% (20%*3%).
- Diversification: Investing in Debt Funds helps reduces the overall portfolio risks as they offer more stable returns. This is thus important for well-diversified portfolio investment.
- Potential to earn higher: Debt funds have the potential to perform better than the traditional saving options. Additionally, you can benefit from lower taxation, if you stay invested for more than 3 years
Short term debt funds
Short-term bond funds are those type of debt funds which invest in securities that have a maturity period of anywhere between a year to three years. These funds usually offer high liquidity. Short term debt funds invest in government securities along with medium and long-term instruments. Income funds, low duration funds, overnight funds are some of the examples of short term funds.
Long term debt funds
Long term debt funds invest in securities that have a maturity period of over five years. Dynamic bond funds, long-duration funds are some of the examples of long term bond funds.
Long term v/s short term: Which Debt fund is better?
Whether an investor should invest in the short term or for the long term shall completely depend on the financial goal of that individual. Investors must be aware that they must try and always align their financial goals with the following factors, in order to choose a debt scheme that may hold the potential to help them earn some returns.
- Financial goal: What is the primary reason behind your investment? Do you have a short term objective like Rajesh of purchasing a bike or a car? Or do you want to invest for the long run and build a retirement corpus? Or are you investing to save enough money for your children’s overseas education? The most important factor an individual should always consider before investing is identifying their main investment objective. Having a defined investment goal usually helps because now investors can look at various investment options and then narrow down to a scheme that aligns with their investment strategy. That’s because different debt funds follow a different business strategy and if having a defined financial goal may help investors in narrowing down to a scheme that aligns with their investment strategy.
- Investment horizon: If you are someone who has a short term investment horizon, then a short term bond fund or a money market fund or liquid fund can be chosen by the investor. That’s because these funds are averse to market volatility and hence investors needn’t worry about losing the invested amount or worry about the fluctuations in the bond market. These can also be ideal for investors with low-risk appetite. But if you are someone who has a high-risk appetite with a long investment horizon, and doesn’t mind exposing their finances to the vagaries of the market, then they can consider investing in a long term debt fund like a gilt fund or a dynamic bond fund.
- Risk appetite: Investors can largely be categorized into two types, those do not wish to expose their financial investment to any type of risk and those, dare to give their portfolio an aggressive approach by putting their money in risky investments with the hope of seeking better returns. Conservative investors with zero risk appetite who are comfortable with slow by steady returns can consider investing in short term debt funds. For such investors, short term bonds which invest in short maturity corporate bonds can be an ideal choice. On the contrary, investors with a high-risk appetite who do not want to settle with low-interest rates and seek long term capital appreciation may consider investing in more aggressive debt funds like guilt funds and dynamic bond funds.
So now that you know how short term and long term debt funds can be added to one’s investment portfolio, what is going be your choice?
