UCITS: Choosing a debt fund? Here’s what you need to know before
What is a debt fund?
Simply put, debt funds are mutual funds that invest investors’ money in securities that earn fixed interest, including government and corporate bonds, debentures, and other money market instruments. Debt funds are also often viewed as more secure as opposed to the volatility that the stock market brings, as debt funds have lower risk but lower returns. They come with varying maturity periods and can generate income either at maturity or periodically.
Debt funds are one of the best investment options for investors with a low tolerance for risk because they are not as volatile as investments in stocks. However, investors, especially those new to investing, often find themselves at a crossroads when choosing the best debt funds for their portfolio, financial goals and needs. With that said, here’s what you need to know before investing in a debt fund.
Fluctuating interest rates
As mentioned earlier, debt funds are fixed investments and fixed investment securities react inversely to interest rates. This means that an increase in the interest rate will lower the returns of the debt fund and vice versa. In addition, the longer the maturity period of the debt fund, the greater the risk of interest rate fluctuations. However, investors might need to keep a long investment horizon to achieve better returns / capital appreciation. Although debt funds are also subject to the risk of interest rate fluctuations, they provide investors with flexibility in entering and exiting the fund.
As an investor, it is essential to understand that debt fund holdings are ranked according to the credit ratings assigned by rating agencies – AAA, AA +, A1 +, etc., and investors can choose funds in depending on that. For example, AAA credit rating means there is lower risk but higher quality, which is more suitable for conservative investors. On the other hand, debt funds that have a lower credit rating may have higher stakes. It is best to opt for a fund that has a majority of high quality bonds but also to do your research thoroughly before considering investing in funds that have a lower rating.
Long-term tax benefits
The length of time that a fund is held has an impact on the tax advantages enjoyed by the investor. Debt funds held for less than a year may result in short-term capital gains tax for the investor. However, debt funds held for more than a year will be subject to a long-term capital gains tax of 20% and will include indexation benefits.
It is imperative to consider the expense ratio before investing in a debt fund. If a debt fund generates returns of 10%, the investor will not receive the full amount since the AMC (Asset Management Company) deducts expenses such as operating expenses and other overheads. This is the expense ratio of the mutual fund that investors will need to watch before choosing a loan fund. It is better to opt for a fund where the expense ratio is minimal.
Diversify your portfolio with risky debt
As mentioned earlier, diversification is a crucial aspect of becoming a successful investor. And there is one segment that needs to be considered, especially if the investor is considering becoming an angel in the future – risk debt funds. Put simply, a risk debt fund invests in startups alongside equity investors, allowing them to meet their working capital needs. However, instead of debt, risky debt funds can earn a share of the capital of the business. Venture capital debt facilitates profitability and growth and is also more affordable than equity. In addition, venture capital debt also does not dilute the founders’ stake in the startup and can provide high returns.
We have often heard “mutual funds are subject to market risk” in several announcements and advertisements. Among the mutual funds available in the market, debt funds are relatively one of the safest with predictable returns, increased liquidity and convenience, making them one of the most sought after investment vehicles. in the market, especially by investors who have a low risk appetite. The only thing to remember would be to do some in-depth homework before you start your investment journey and check out the top performing funds for maximum return.
The writer is co-founder and CEO of Mumbai Angels.