Non-equity mutual funds are investment schemes that invest in financial instruments other than company shares or equities. These funds focus on debt securities, government bonds, treasury bills, and other fixed-income instruments.
In recent times, these mutual funds have become a popular investment choice among investors. Thanks to their stable returns and low risk, they are highly preferred by conservative investors with low-risk appetite. Let’s understand non-equity-oriented mutual funds in detail, see their various types, and learn how they work through easy examples.
What are non-equity mutual funds?
Non-equity mutual funds, as the name suggests, do not allocate their assets to stocks and company equity. These funds invest in different fixed-income securities, such as:
- Government bonds
- Money market instruments
- Treasury bills
- Corporate bonds
These schemes offer stable returns to investors and carry lower risk compared to equity funds. These characteristics make them suitable for conservative investors or those seeking regular income.
Also, investors looking to diversify their portfolios and preserve capital can invest in non-equity mutual funds. That’s because they offer a safer alternative to the more volatile stock market.
Example of non-equity mutual funds
Say the XYZ Gilt Fund is a popular top-performing non-equity mutual fund. This fund aims to generate risk-free returns by investing in securities issued by the Government of India, like government bonds and treasury bills, which have minimal default risk.
The fund earns income through the interest paid on the government securities it holds. This interest income is passed on to the investors, who receive regular returns.
It must be noted that the Net Asset Value (NAV) of the fund fluctuates based on changes in interest rates. Usually, when interest rates fall, the prices of existing bonds rise. This also increases the fund's NAV. On the other hand, an increase in interest rates negatively impacts the NAV of the fund.
Hence, as a gilt fund, it carries low credit risk but is subject to interest rate risk. Furthermore, the fund offers high liquidity. This means investors can redeem their units on any business day.
How do non-equity mutual funds work?
Most non-equity mutual funds work by pooling money from several investors to invest in a variety of fixed-income instruments (other than stock). Let’s understand in simple steps how these funds operate:
Step I: Pooling money
- Investors put their money into the mutual fund.
- Each investor owns units of the fund.
- Each unit represents a share of the total investments.
Step II: Investing in instruments other than equity
- The fund manager uses this pooled money to buy fixed-income securities like:
- Government bonds
- Corporate bonds
- Treasury bills
- Money market instruments
- These investments are generally considered safer,
- Also, they are less volatile than stocks.
Step III: Earning interest
- The investments generate income through interest payments.
- For example,
- Say a non-equity-oriented mutual fund buys a bond
- Now, the issuer of the bond pays interest to the fund regularly
Step IV: Distributing returns
- The fund collects the interest income.
- This income is then distributed to the investors in the form of dividends.
- Alternatively, it can also be reinvested to buy more units of the fund.
- This choice of distribution depends on the investor.
- Also, sometimes the fund may also appreciate (increase in NAV) if the market conditions are favourable.
Step V: NAV calculation
- It is noteworthy to state that the value of the fund’s investments is calculated daily to determine the Net Asset Value (NAV)
- For the uninitiated, this is the price at which investors can buy or sell units of the fund.
Types of non-equity mutual funds
Non-equity mutual funds come in various types. Each focuses on different fixed-income securities. However, the basic nature of all these funds remains the same. All such funds are designed to:
- Offer stable returns, and
- Carry lower risk compared to equity funds
Now, let’s study the different types of non-equity mutual fund schemes:
1. Debt funds
The debt funds invest primarily in fixed-income instruments like:
- Government bonds
- Debentures
- Corporate bonds, and more
These funds generate regular income with relatively lower risk. Also, the returns from debt funds are more stable compared to equity funds which makes them suitable for conservative investors.
2. Money market funds
Money market funds invest in short-term debt instruments such as:
- Treasury bills
- Commercial paper, and
- Certificates of deposit (CDs)
These funds offer high liquidity with comparatively low risk to equity mutual funds. They are ideal for investors looking to safely park their money for short durations while earning a slightly higher return than a savings account.
3. Liquid mutual funds
One should be aware that liquid mutual funds are a subset of debt funds. Usually, they invest in very short-term instruments with maturities of up to 91 days. These funds are designed to provide maximum liquidity. This makes them perfect for parking surplus cash for very short periods.
Additionally, they offer returns comparable to savings accounts but with higher flexibility and quick access to funds.
4. Fixed maturity funds
Fixed maturity funds (FMFs) are close-ended funds. This means investors can buy units only during the initial offer period and hold them until maturity. FMFs invest in debt securities with a fixed maturity period that usually ranges from a few months to a few years. The main goal of these funds is to provide predictable returns by holding securities until they mature.
5. Pension funds
Pension funds invest in a mix of:
- Fixed-income securities, and
- Other low-risk instruments
They provide stable returns over the long term and are specifically designed for retirement planning. Most pension funds focus on capital preservation and steady growth.
Additionally, they follow a conservative investment strategy to ensure that the accumulated corpus provides “regular income” post-retirement.
Who should invest in non-equity mutual funds?
Non-equity mutual funds are ideal for conservative investors looking to get stable returns with lower risk. In most cases, they suit individuals who prioritise capital preservation and are looking for regular income, such as:
- Retirees, or
- Those nearing retirement
Moreover, these funds are also beneficial for investors with short- to medium-term financial goals, such as:
- Saving for a down payment on a house, or
- Funding a child's education
Also, by investing in non-equity mutual funds, investors can diversify their portfolios and reduce exposure to the stock market's volatility.
Taxation on non-equity mutual funds
As per the Income Tax Act of 1961, the taxation on non-equity mutual funds depends on the holding period of the investment. Let’s see how:
Short-Term Capital Gains (STCG)
When you hold non-equity mutual funds for less than 36 months (3 years), the profits are classified as short-term capital gains. These gains are taxed according to the investor's relevant income tax slab rate.
Long-Term Capital Gains (LTCG)
On the other hand, when you hold non-equity mutual funds for more than 36 months, the profits are classified as long-term capital gains. These gains are taxed at 20% with the benefit of indexation. For those unaware, indexation adjusts the purchase price of the investment for inflation. This adjustment increases the cost of acquisition (COA) and helps in reducing the LTCG.
Furthermore, dividends received from non-equity-oriented mutual funds are taxed as per the investors’ income tax slab rate.
Conclusion
Non-equity mutual funds are investment schemes that invest in fixed-income instruments such as government bonds, treasury bills, commercial papers, and more. They offer stable returns with lower risk and are more suitable for conservative investors, retirees, and those with short-to-medium-term financial goals.
Furthermore, these funds also help in diversifying investment portfolios and reducing exposure to stock market volatility. When it comes to taxation, the ultimate tax liability depends on the holding period of an investor. As per the Income Tax Act , short-term gains are taxed at the investor's income tax rate, and long-term gains are taxed at 20% with indexation benefits.
