What are debt funds: Types and key risks to keep in mind

Debt Mutual Funds are those where money is invested in a mix of debt or fixed income securities such as treasury bills, government securities, and corporate bonds. Debt mutual funds are meant for low risk-takers because these offer a fixed rate of income on a fixed maturity, unlike equity funds where volatility is high. This also limits the returns.

The returns on debt fund have two components: Interest income and capital appreciation/ depreciation due to changes in interest rate dynamics. 

Why you should invest in debt funds:

India is a high interest rate economy as compared to developed countries. Interest rates offered on debt funds can go as high as 9-10 per cent. The recent two non-convertible debentures from DHFL and JM Financial offered coupon rate up to 9.75 per cent. 
Tax implications:

Tax rates on fixed deposits (FDs) can go up to 33 per cent, said Feroze Azeez, Deputy CEO, Anand Rathi Wealth Management. However, the longer one holds a debt fund, the lesser the tax rate turns out to be. Tax is charged on debt funds in the form of capital gains, which becomes negligible after 3-4 years, he said. 

Types of debt funds:

i) Short-term debt funds: Liquid Fund/Low Duration Funds. Good for creating emergency corpus
ii) Medium-term debt funds (18 months to three years): Short Term fund/Credit Risk Funds
iii) Long-term debt funds: Bond Funds

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Debt funds: Key risks 

Interest rate risks on longer maturity: Bond prices are affected by the interest rate cycles and policy stance of central banks. Higher the average maturity, the more volatile and risky is a fund considered.

Credit risks: Credit risk is about the fund's ability to pay back money at the time of maturity. The lower the rating profile of a fund’s investment, the more risky is it considered.

"Longer maturity risk is normally due to fluctuation in bond prices and is considered recoverable over long periods. Credit risk is typically binary in nature, where if the investee company defaults in repayments on due date, the subsequent recovery is generally unlikely," said Mahendra Jajoo, head- fixed income, Mirae Asset Global Investments.