What are the advantages and disadvantages of debt mutual funds? (2024)

FAQs

What are the advantages of debt mutual funds? ›

Debt mutual funds are a safer avenue for risk-cautious investors. In other words, debt fund schemes are preferred by investors who are comfortable with the prospect of a low yet daily rate of returns over high-risk capital exposure.

While debt funds are generally considered safer than equity funds, they are not entirely risk-free. Factors like interest rate risk, credit risk, and liquidity risk can affect the performance of debt funds.

Pros of debt financing include immediate access to capital, interest payments may be tax-deductible, no dilution of ownership. Cons of debt financing include the obligation to repay with interest, potential for financial strain, risk of default.

Investing in debt funds carries various types of risk. These risks include Credit risk, Interest rate risk, Inflation risk, reinvestment risk etc.

Flexi FDs offer the flexibility to withdraw funds without penalty. However, if you opt for regular FDs, you may have to pay the penalty for early withdrawal. Conversely, debt funds impose no exit loads after a certain period. Therefore, debt funds provide greater liquidity and can be more cost-effective than Bank FDs.

Debt mutual funds do not have a definite lock-in period. As a result, it can be redeemed within one or two days of placing the request for redemption. These funds can be available throughout a variety of credit risk and maturity. There are shorter duration funds, liquid funds, overnight funds, low duration funds, etc.

Adverse impact on credit ratings

If borrowers lack a solid plan to pay back their debt, they face the consequences. Late or skipped payments will negatively affect their credit ratings, making it more difficult to borrow money in the future.

Disadvantage: High-Interest Rates

That could potentially make the loan very difficult to repay. There is also the possibility that the terms of the loan can change during the life of the loan, making it unfavorable for your business.

Since Debt is almost always cheaper than Equity, Debt is almost always the answer. Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

Debt Mutual Funds cover a wide range of debt securities and each security is affected by the changes in interest rates. As a result, the best time to invest in Debt Funds is usually when interest rates are decreasing or expected to drop.

Which type of debt fund is safest? ›

In fact, it is advisable to invest in short-term debt funds for your near-term goals, as the value of long-duration funds is likely to fall more when there is an increase in interest rate. Which debt funds are safe? Overnight Fund is the safest among debt funds.

If the interest rate in the economy falls, new instruments issued in the market would offer this lower rate. To match this lower rate, there would be an increase in the prices your fund's underlying instruments as they have a higher coupon (interest) rate.

While most FDs offer 6 to 7 percent interest, debt mutual funds deliver anywhere between 7-8 percent return in one year. Tax treatment: When seen from the tax treatment's perspective, the difference ceased to exist when in Finance Act 2023, indexation benefit of long-term debt mutual funds was phased out.

Mutual funds offer diversification or access to a wider variety of investments than an individual investor could afford to buy. Investing with a group offers economies of scale, decreasing your costs. Monthly contributions help your assets grow. Funds are more liquid because they tend to be less volatile.

Interest payments on certain types of borrowed funds may be tax-deductible, providing potential tax benefits for borrowers. It can help individuals and businesses manage liquidity and cash flow, especially during periods of economic volatility.

The main difference between debt fund and equity fund is that debt funds have considerably lesser risks compared to equity funds. The other major difference between debt mutual fund and equity mutual fund is that there are many types of debt funds which help you invest even for one day to many years.