Debt funds are like equity mutual funds. But instead of stocks, debt funds invest in government bonds, corporate bonds, certificate of deposits, commercial papers and other fixed income instruments of varying maturities. Even though debt funds invest in fixed income instruments, the returns from debt funds are not fixed as in a bank fixed deposit.
The normal wisdom is that debt investments would give consistent and sedate returns with low to very low risk. And equity markets have the potential to offer high returns, but are prone to fluctuations and is meant for those who have a high risk appetite. While this is still broadly true, debt funds over the past one year have outperformed equity funds by a big margin with over 7% average category returns against less than 5% of equity funds.
A clear trend has emerged in the last few months with bond funds outselling equities by a substantial margin. In-fact, between April and July this year, investors poured nearly Rs 450 bn into debt funds. This was a 65% jump over the same period last year. Short-term and dynamic bond funds attracted the most capital. Their size has increased from Rs 17 bn to a whopping Rs 120 bn in just one year. Dynamic bond funds are a class of funds which can shift quickly across different types of debt, based on where opportunities lie. So what makes these funds so attractive over traditional debt instruments?
There are several reasons for this. First, for investors in the higher tax brackets, returns from debt funds suffer lower tax due to indexation benefits and dividend distribution tax. This makes them attractive relative to bank deposits. Second, they are more liquid than traditional fixed deposits. One can withdraw their investments at any time and the money will be in their bank account the next day. Unlike a fixed deposit, the fund house does not levy a penalty for exiting too soon. Third, Preservation of capital is a major advantage. The potential for capital appreciation and higher returns that the traditional debt instrument offers can be maximized from these funds.
However by nature of their investments and the tax treatment, these are for investment for the short term only.