Debt funds are investment instruments that offer a compelling combination of low risk, steady returns, and high liquidity. Unlike equity mutual funds that invest in stocks, debt funds primarily allocate your money to fixed-income securities. Their portfolio is composed of corporate bonds, government securities, treasury bills, commercial papers, etc. These fixed-income instruments provide regular interest payments, making debt funds akin to loans where you earn money through interest. Let’s look at the five strategies for debt fund investment.

Strategies for debt fund investment

1. Consider credit ratings

Credit ratings are a barometer for the underlying securities' creditworthiness within the fund's portfolio. Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency of India Limited (ICRA), Credit Analysis and Research Limited (CARE), or other recognised bureaus assign these ratings.

A higher credit rating suggests a lower risk of default. Such funds can appeal to conservative investors seeking stable returns with minimal risk exposure. Conversely, lower-rated securities might offer higher yields but come with an increased risk of default.

Credit ratings also influence the price of securities. Debt instruments with a higher rating trade at a premium because of their perceived safety. Lower-rated securities might trade at a discount to attract investors and hide the associated risks.

2. Understanding tax rules

Knowing about taxation is crucial for planning an effective exit strategy.

The recent changes in the tax laws, effective from April 1, 2023, have significant implications for investors in debt mutual funds.

Previously, debt funds held for over three years were subject to Long-Term Capital Gains (LTCG) taxed at 20% with indexation benefits. Indexation means adjusting the purchase cost for inflation to reduce the taxable gain. This made debt funds an attractive option for investors in higher tax brackets.

However, the new rule has removed the indexation benefit for funds that invest less than 35% in the equity shares of domestic companies. Now, gains from debt funds will be taxed at the investor’s income tax slab rate, irrespective of the holding period.

3. Consider diversification

Diversification means spreading investments across various securities to minimise the risks associated with any single asset. Debt funds are responsive to changes in interest rates. For example, longer-term bonds tend to be more volatile when rates fluctuate. If you diversify across bonds with varying maturities, you can deal with the interest rate risk.

Besides interest rates, there is credit risk. Due to the financial crunch, the bond issuer might fail to pay the investors the interest.

For effective diversification, you can consider a few of the following options:

• For short-term liquidity needs, consider liquid funds with very short maturity periods (up to 91 days)
• Invest in slightly longer-term debt securities (1-3 years) like short-term funds for better returns
• Ultra short-duration funds offer slightly higher returns while maintaining liquidity (3-6 months)
• Income funds diversify across various debt instruments for regular income
• Gilt funds invest in government securities for lower risk
• Dynamic bond funds adjust portfolio duration based on interest rate scenarios.
• Corporate bond funds offer higher returns from high-rated corporate bonds
• Fixed Maturity Plans (FMPs) offer a fixed investment horizon with aligned maturities

4. Understand the role of fund managers

Fund managers align the maturity schedules of the investments with the anticipated interest rate movements. This active duration management is essential, especially in volatile markets where interest rates can fluctuate, affecting the value of the underlying debt instruments.

Moreover, fund managers are responsible for implementing various strategies. For example, they take a roll-down approach, maintaining a portfolio of bonds to mature at the same future date. This strategy can offer predictable returns in an uncertain interest rate environment. However, with expectations of falling interest rates, some fund managers are shifting away from this strategy to avoid reinvestment risk, which occurs when cash flows from the portfolio must be reinvested at lower rates.

5. Have an objective

An investment without a goal lacks purpose and direction. You should be clear about whether you are investing for retirement, purchasing a home, or supporting your child's education.

An objective specifies the time frame in which you want to remain invested. If you wish to buy a house or a car within the next 2-3 years, you may be unable to do so only through debt financing. To maintain a balanced strategy, you must allocate some funds to equities.

Read More: What is a Demat Account?

Summing up

Debt funds are prudent for investors seeking stability and predictable returns. They offer diversification, lower risk, and adaptability to interest rate changes, guided by expert fund managers. However, you must be mindful of credit ratings and recent tax law changes.

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