Are Debt Mutual Funds Suitable for Passive Income?

In today's world, rising living costs, early retirement and the increasing expense of higher education etc. have become a growing concern for many people. Individuals are increasingly looking for ways to generate additional streams of income. While salaries and business earnings are often the primary sources of income, passive income has emerged as an alternative. Once set up, passive income can help you earn funds regularly without continuous effort. Among various investment options available, a debt mutual fund is always a reliable option to ensure passive income generation. Now, let's see how the debt mutual fund can help in generating passive income through investment.

Passive income refers to funds earned without requiring constant time and effort. You could continue to earn with the least effort after establishing an income source. Some common sources of passive income include:

• Dividends: Income from stock investments.
• Interest Income: Funds earned from savings accounts, fixed deposits, and debt funds.
• Trading: Income earned from holding long-term positions in stocks that appreciate over time, providing passive income.

Building passive income requires effort initially, such as writing a book or investing in real estate. However, once set up, these income sources continue to generate funds with minimal ongoing involvement.

Debt mutual funds are the type of mutual fund that entails investments in fixed-income instruments, such as bonds, treasury bills, commercial papers, and other forms of short-term debt obligations. Such mutual funds have been specially designed for providing low-risk steady returns to the investors. Hence, they can be a suitable option for generating passive income. 

Though debt mutual funds are an excellent tool to generate passive income, there are some essential considerations before investing that should be kept in mind. They help determine the right kind of fund you are looking for and how much risk you are willing to take.

1. Expense Ratio

The expense ratio is an annual charge levied by the fund house for managing the fund. This charge is usually deducted from the returns of the fund. In the case of a debt mutual fund for passive income, one needs to compare the expense ratios of various funds. Lower expense ratios lead to higher net returns for the investor. Over time, small differences in expense ratios can have a significant impact on overall returns, so you should choose funds with a reasonable expense ratio.

2. Risk Tolerance

While debt funds are typically viewed as low-risk investments, not all debt funds are equal. Some might have an investment in longer-duration bonds, which are highly sensitive to interest rates. Hence, they could have a higher risk. Evaluate your risk tolerance and make appropriate fund choices.

For example, if a person is a conservative investor, he or she will like liquid funds or short-duration debt funds. However, if the individual is comfortable with high risk, then he or she can choose investments in funds that invest in longer-term bonds or corporate debt.

3. Investment Choice: IDCW vs. Growth

The debt mutual fund typically offers two types of investments: Growth and IDCW (Income Distribution cum Capital Withdrawal).

• Growth Option: In this type of investment, the income generated from the fund automatically gets added to the principal, which contributes to higher compounding in the long term. Such an option can suit investors who don't want payouts but look for capital growth in the long term.
  
  
• IDCW Option: In this option, the income generated by the fund is paid out to the investor regularly. If your goal is to generate regular passive income, the IDCW option is a better choice.

Carefully consider your income needs and investment goals before choosing between the Growth and IDCW options.

4. Time Horizon

Your time horizon is the period you expect to keep the funds invested in a fund. If you are investing with a long-term horizon in mind, you may favour funds that offer higher yields, such as corporate bond funds and long-duration debt funds. Whereas, for short-term requirements, liquid funds are a reliable option, as they help preserve the principal invested and easy access to raising funds.

5. Fund's Past Performance

Past performance doesn't determine future results, but the historical performance of a debt mutual fund may give an idea of how stable a fund is and whether the fund can deliver favourable returns. 

Before making any investment, it’s important to consider the tax implications. There have been significant changes, especially after Budget 2023. Here’s the taxation for DMFs:

Before April 2023:

• STCG (Short-term capital gains): Up to 3 years - Taxed at the income tax slab rate.
• LTCG (Long-term capital gains): Over 3 years - Taxed at 20% with indexation benefit.

After April 2023 (changes in taxation):

• STCG: Up to 3 years - Taxed as per the income tax slab (maximum 30%).
• LTCG: Beyond 3 years - No tax.

Liquidity needs and emergency fund provisions: Retirees should have liquidity for 3 to 6 months, as life can be unpredictable. Having an emergency fund helps cover unexpected expenses.

There are 16 types of debt funds available in the Indian market. Each fund has different periods of maturity, specific goals, and risk tolerance levels. Let’s know about each of them in brief:

1. Liquid Funds: These debt instruments mature within 91 days, similar to Treasury bills and commercial papers. The returns are low due to the low risk involved.
2. Overnight Funds: These funds are like savings accounts. You can park your money for a very short period, and the fund matures in one day. This is a very safe investment.
3. Low-Duration Funds: These funds invest in bonds with a Macaulay duration of 6 to 12 months. Due to the longer maturity, the risk is slightly higher than that of ultra-short-duration funds.
4. Ultra Short-Duration Funds: These funds invest in bonds with a Macaulay duration of 3 to 6 months. The risk is low as the maturity is short.
5. Short-Duration Funds: These funds invest in bonds with a Macaulay duration of 1 to 3 years.
6. Medium Duration Funds: These funds invest in bonds with a Macaulay duration of 3 to 4 years. The risk is moderate, and investors should assess the risks involved before investing.
7. Medium to Long-Duration Funds: These funds invest in bonds with a Macaulay duration of 3 to 7 years. The funds carry high-interest rate risk.
8. Long-Duration Funds: These funds invest in bonds with a Macaulay duration of more than 7 years. The risk is high, though it is still lower than equity mutual funds.
9. Dynamic Bond Funds: The fund manager invests across durations and adjusts the tenor of securities as interest rates change.
10. Floater Funds: These funds primarily invest 65% of the corpus in floating-rate bonds.
11. Gilt Funds: These funds invest 80% of their corpus in government securities with various maturity periods. These carry less risk due to the sovereign guarantee.
12. Gilt Funds with 10 years- constant Duration: These funds are similar to regular gilt funds but have an additional duration of 10 years.
13. Banking and Public Sector Undertaking (PSU) Funds: These funds invest 80% of their corpus in bonds issued by banks, PSUs, and public financial institutions.
14. Corporate Bond Funds: These funds invest 80% of their corpus in high-rated corporate bonds, depending on the credit rating of the securities.
15. Credit Risk Funds: These funds are similar to corporate bond funds but invest 65% in lower-rated corporate bonds.
16. Money Market Funds: These funds invest in high-quality, short-term debt instruments such as Treasury bills and cash equivalents.

Every investment carries some risk. The three main risks in debt funds are:

1. Liquidity/default risk
2. Interest rate risk
3. Credit risk

Investors need to check where their funds are invested.

Generating passive income through debt mutual funds can be a feasible option. They provide relatively low risk, high liquidity and steady returns. It is accessible, even to small investors. Before starting, one should look for expense ratios, risk tolerances, and investment options such as IDCW and Growth. A disciplined investment approach, after choosing reliable funds carefully, can provide a reliable source of passive income over time to sustain long-term financial goals without much effort.