Debt Funds – Meaning, Types, Benefits, Best Debt Funds

What are Debt Mutual Funds?

Open-ended mutual fund schemes that predominantly invest in fixed-income debt securities are known as debt funds. The underlying assets comprises treasury bills, government bonds, certificate of deposits, debentures, corporate bonds and various other money-market instruments.

Debt funds are one of the safest investment instruments available to investors, who wish to earn optimal returns on their investment, without betting on risky avenues. Also, the returns are quite stable, as opposed to returns from equity funds which are highly volatile.

Benefits of Investing in Debt Mutual Funds

• Fixed Returns

As debt funds primarily invest in securities that yield fixed-interest, returns from them are guaranteed. However, there is a minuscule possibility of a debt fund not performing upto the mark, this happens when the invested securities have low credit rating, or the interest rate movement is negative.

• High Liquidity

Overnight Funds or Liquid Funds are categorised under debt funds which have delivered optimal returns in the short run over the years. These funds are highly liquid and are a perfect safe haven for idle money in hand. One can redeem the units as per his/her convenience.

• Better Returns than Traditional Savings Methods

When compared to returns delivered by traditional savings methods such as Savings Accounts or Bank Fixed Deposits, debt funds have always fared well. While savings accounts have delivered around 4-5% annual returns over the years, liquid funds have delivered returns at the average rate of 7%. Also, instant redemption facility in case of liquid funds make them a better alternative to savings accounts.

• Diversification

When it comes to investing, it is recommended to construct your investment portfolio as diverse as possible. A diversified portfolio is the first step to effective risk mitigation. It is recommended to invest in that debt fund which has appropriate allocation to various money market instruments, instead of concentrating on single debt security.

• Professional Management

Instead of individually selecting a debt security for investment, it is advisable to invest in a debt fund, where a professional fund manager formulates a portfolio of multiple securities, after proper analysis of market sentiment and interest rate movements.

Tax implications on Debt Mutual Funds in India

• Taxation on debt mutual funds depends on the holding period of the fund units. If an investor redeems the fund units before 3 years of investment, Short Term Capital Gains (STCG) Tax, as per the income tax slab of the investor is levied.
• For instance, If an investor has made a capital gain of ₹50000 on investment in a debt mutual fund and withdraws the amount before 3 years of investment, Short Term Capital Gains Tax would be levied, as per the income tax slab of the investor. ₹50,000 would be added to the taxable income of the investor and taxed accordingly.
• If an investor withdraws the investment including capital gains post 3 years of investment, 20% Long Term Capital Gains Tax of 20% is levied, with the benefit of indexation. Indexation reduces the value of overall Long Term Capital gains to reflect the effect of inflation on your investment.
• To calculate the final value of capital gains post indexation, we use government’s Cost Inflation Index (CII) in the following formula:

Indexed cost of Acquisition = Investment Amount * (CII of the year of withdrawal/ CII of the year of investment)

Suppose the investment amount is ₹70,000 in the year 2016 and the withdrawal  amount is ₹1 Lakh. The value of capital gains is ₹30,000 before indexation

Indexed Cost of Acquistion= 70000* (280/254) = 77165.35

Note: CII in the year 2015 = 254

CII in the year 2018 = 280

Final Value of Capital Gains= 100000- 77165.35 = 22834.65

Tax Payable = 20% of 22834.65 = 4566.93

How to Pick the Right Debt Fund?

• Financial Objective of the Investor

One should select the debt fund as per his/her financial goal. If you’re looking for avenues to park idle cash for a short term, liquid funds are the best choice. If you want to save to meet a short term financial goal such as buying a car, or education expenses, you can opt for medium to long duration debt funds.

• Investment Horizon

If you have an investment horizon of around 3 months to 1 year, it is advisable to invest in liquid funds. If the tenure of investment is more than 1 year and less than 3 years, you can opt for short term debt funds. Medium to long duration debt funds are recommended to investors with investment horizon of more than 3 years. Maturity period of the portfolio is also an important parameter for selecting the best debt fund for you.

• Risk Appetite

Debt funds are not entirely risk-free. Credit risk and interest rate risk are quite prevalent in these funds. Credit risk arises when the portfolio consists of securities with low credit rating. Whereas interest rate risk arises when any change in interest rate negatively affects the prices of the bonds. It is advisable to carefully analyse the fund’s historical performance and portfolio allocation, to get an idea of risk exposure of the fund.

• Expense Ratio And Exit Load

Compared to equity mutual  funds, returns from debt are quite low. Because of this, it becomes highly important to invest in a fund which has a low expense ratio. Also, some debt funds also charge an exit load to prevent premature withdrawal from the fund. This should also be taken into consideration before picking up the right debt fund for investment.

Who Should Invest in Debt Funds?

• Risk averse investors who are looking to park their money either for short term to earn decent returns (preferably more than savings account), or invest for 3-4 years can opt for debt mutual funds for investment.
• Debt funds are recommended to conservative investors who don’t want to place a bet on equity funds. Investment in debt funds ensures that your money is invested in safe financial instruments that are going to deliver fixed returns at maturity.
• Investors looking for an alternative investment option to fixed deposits, but with high liquidity can opt for debt funds. Unlike bank fixed deposits, debt funds don’t have any lock-in period.
• If you wish to earn stable returns, although smaller when compared to those from equity funds, you can consider the aforementioned debt funds for investment.

Here is a List of Top Debt Funds to Invest in 2020