Q. I am a 35-year old working professional. I wish to invest in the debt space, but I am confused between debentures and debt mutual funds. Which is the better option between the two?
Ravindra Singh Makhija, Noida
Investment in debt is comparatively less riskier than investment in equity. Typically, there are multiple avenues available with an individual in relation to investment in debt such as investment in debentures, bonds, government securities, peer to peer lending, etc. However, the most popular option amongst salaried individuals historically has been investment in debt mutual funds and investment in debentures.
Both options have their strengths and weaknesses. In case of investment in debt mutual funds your money will be invested in fixed income securities such as bonds, debentures, corporate deposits, money market instruments etc., of various companies.
In case of investment in debentures your money is lent to a particular company who will be issuing you debentures and will be paying you interest on a frequent basis. Please see below key differences between the two:
Investment target
In case of debt mutual funds your money will be invested in fixed income securities of a number of companies which will consequently decrease your risk significantly.
In case of debentures you will be subscribing to debentures of a particular company, in the event if that one company goes bankrupt you will be getting close to negligible returns that also only after the insolvency resolution process is over.
Returns
In case of debt mutual funds, returns are not guaranteed, investments in mutual funds including debt mutual funds are subject to market risk. Top 5 debt mutual funds have historically provided CAGR of above 6% (per year) in the past 5 years.
In case of debentures, different companies offer different interest rates. Typically blue chip companies with high creditworthiness and consequently having higher credit rating will offer lower rate of interest and smaller companies with lower creditworthiness and consequently lower credit rating will offer higher interest rates. Typically companies offer interest ranging from 4 percent to 12 percent depending on their creditworthiness and market standing.
Risk
In case of debt mutual funds because your money is invested in a number of different companies your risk of losing all of your money is relatively low.
In case of debentures it is legally mandatory for the issuer company to get the debentures’ creditworthiness rated from a credit rating agency. Different companies’ debentures have different credit rating. Credit rating essentially indicates the probability of the company defaulting on payment of interest and principal. Theoretically credit rating of debenture is very much similar to how credit bureaus estimate the creditworthiness of Individuals through credit score mechanism.
Fee
Mutual funds schemes are managed by asset management companies, which manage your investment in the mutual fund scheme professionally. Asset management companies charge a certain amount (expense ratio) every year to the investor for managing their investment.
In case of debentures the issuing company does not charge any fee or commission to the purchaser of the debentures.
Lock-in
In case of debt mutual funds typically you can redeem your investment at any time, only a few debt mutual funds have a lock-in period.
Debentures can be redeemed only at the time of their maturity. Debentures have different tenures, typically most companies issue debentures having maturity between one and seven years.
Liquidity
As stated previously most debt mutual funds do not have a lock-in period and therefore can be redeemed at any point of time and consequently are highly liquid.
Debentures which are listed on a stock exchange can be traded in a fashion similar to shares, however, the volume of debenture traded are typically low which leads to reduced liquidity.
Tax efficiency
Short term capital gains in case of debt mutual funds is taxed basis the applicable tax slab of the investor, i.e. for ex. if you are in the highest tax bracket your short term capital gains will be taxed at the rate of 30 percent. Long term capital gains are taxed at the rate of 20 percent with indexation benefits.
Interest income in case of debentures is classified as ‘other income’ and taxed per your income tax slab i.e. for ex. if you are in the highest tax bracket your income from interest will be taxed at the rate of 30 percent.
Portfolio
In case of debt mutual fund the asset management company will be selecting the companies in which your money will be invested.
In case of investment in debentures you will be required to undertake research and select yourself the companies in which you will be investing.
Conclusion
Debt mutual funds as well as debentures are two options which offer reasonable return without exposing the investor to a high amount of risk. One can consider investing in either of the two after considering the parameters listed above and after reading the offer document in detail.
Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
Kuvera is a free direct mutual fund investing platform.
