Debt Mutual Funds

Debt mutual funds are investment funds that put your money into fixed-income securities like government bonds, treasury bills, debentures, commercial paper, certificates of deposit and other money market instruments. 

These securities act like loans made to companies or the state in exchange for a pre-determined interest that the buyer can earn on the maturity of the security. It is comparatively less affected by market fluctuation and therefore, it usually offers a lower but steady and safer returns than equity.

• You invest money in a debt mutual fund and get fund units based on the current Net Asset Value (NAV).
• A fund manager uses the money invested by you and other investors to make decisions on buying, holding or selling fixed income securities, including government securities, corporate bonds, treasury bills, commercial papers and certificates of deposit based on the fund’s objectives and market conditions.
• The fund manager also ensures that the issuers and the instruments are diversified so that the impact of any one default is minimised.

These investments derive income mainly from interest (coupon) income of the underlying securities. The fund also may earn capital gains if the market value of the securities increases due to the effect of interest rate changes or other market factors. After deducting fund expenses, these earnings are reflected in the fund's Net Asset Value (NAV), which determines the value of your investment. Since debt mutual funds are market-linked, their returns are not guaranteed and may fluctuate based on interest rate movements and the credit quality of the underlying securities. 

The relationship between market interest rate and bond prices is mathematically inverse. When the market interest rate falls, existing bonds with older, higher coupons become highly valuable, pushing their prices up. In short, 

Understand this through an example-  

• When Interest Rate Rises- You hold a debt fund of corporate bonds at 6% interest rate. The central bank raised interest rates and issued new bonds at 8% interest rate. Now no one investor wants to buy your bonds of 6% Interest rate, when they can get bonds of 8% interest rate elsewhere.  

To sell that bond, your fund manager reduces its price. As a result the NAV of your bond falls and it hurts your overall returns. 

• When Interest Rate Falls-  When the central bank lowers interest rates and newly issued bonds are at 4%, your 6% interest rate bond becomes extremely valuable because it can be easily sold. Your NAV of the bond will increase as a result of your overall returns too.

Based on your investment objectives i.e. short or long term duration, credit quality and fund managers strategy, the debt mutual fund can be classified into the following categories:  

Debt Mutual Funds Classified Based On Duration

• Overnight Fund- These funds invest in securities that have a one day maturity period. Making them ideal for those who want high liquidity as it matures in just 24 hours.
• Liquid Fund- These funds invest in debt and money market securities for up to 91 days of maturity period. Make a good alternative for short-term investment options.
• Ultra Short Duration Fund- Invest in money market instruments and debt with Macaulay duration of the portfolio between 3 months to 6 months.
• Low Duration Fund- It invests in debt and money market instruments for a period of 6 months to 12 months.
• Money Market Fund- It invests in money market instruments for a maturity period of maximum 1 year. Ideal for short-term goals such as holiday and wedding etc.  
• Short Duration Fund- It invests in debt securities and money market instruments in a manner that the Macaulay duration of the scheme is between 1 year and 3 years.
• Medium Duration Fund- It invests in such debt securities that mature in Macaulay duration of between 3 years and 4 years.
• Medium to Long Duration Fund- It invests in debt securities and money market instruments with a Macaulay duration between 4 years and 7 years, making them ideal for short and long-term financial goals.
• Long Duration Fund- It invests in money market instruments and debt securities with a  Macaulay duration of more than 7 years.  
• Dynamic Bond- It is an open-ended debt mutual fund that has the flexibility to alter its investment portfolio's duration based on changing market interest rates.

Debt Mutual Funds Classified Based On Credit Quality

• Gilt funds- It invests a minimum of 80% of the total fund in government securities. And it has no maturity restriction, which gives it the flexibility to invest in different durations based on changing market interest rates.  
• Corporate bond funds- It invests at least 80% of the total fund in corporate bonds of AA+ and higher ratings. It ensures the risk of a company failing to repay the loan (credit risk) is low. The fund offers comparatively higher returns than gilt funds.
• Credit risk funds- It invests at least 65% of the total fund in AA and below rated corporate bonds. Such funds generally offer significantly higher regular interest payouts than any other category of debt mutual funds. Those who understand their principal amount is not completely safe and are willing to take corporate default risk to chase equity-like returns from debt funds, can invest.       

Debt Mutual Funds Classified Based On Strategy

• Target maturity funds- These funds are open-ended passive debt mutual funds which have a fixed maturity date and invest exclusively in high-quality bonds (usually G-Secs, State Development Loans (SDLs) and AAA rated public sector bonds) that match that timeline. Unlike traditional open-ended debt funds that roll their portfolio forward indefinitely, a target maturity fund functions similarly to a traditionally fixed deposit (FD) which counts to a specific closure date and pays out investors when it ends.

• Floater funds- It invests a minimum 65% of the total assets in both fixed and floating rate instruments. Floating rate instruments interest rate reset periodically so that the fund earns coupon income that is in line with current interest rates in the market and eliminates interest rate risk of the investors to a large extent. 

Follow these simple steps to invest in debt mutual funds via Paisabazaar app:  

Step 1: Open your Paisabazaar app
Step 2: Navigate ‘Mutual Funds’ under ‘Investment Products’ section
Step 3: Filter or search for Debt Fund (Fixed Income)
Step 4: Explore funds and choose one that fits your risk-appetite and financial needs.
Step 5: Choose the frequency (One-time or SIP) and amount
Step 6: Complete the KYC process and start investment

Debt mutual funds may be suitable for:

• Investors who prefer lower volatility and safer capital preservation than equity funds 
• Investors having short- to medium-term financial goals
• Retirees looking for regular and steady cash flow
• Investors seeking to balance out their high-risk equity investments to diversify and stabilise their overall portfolio.

• Interest Rate Risk: NAV of debt funds, especially long-duration funds, may fall if interest rates rise.
• Credit Risk: If the issuer of a bond defaults or if the credit quality of the issuer deteriorates, the fund’s return may suffer.
• Liquidity Risk: Some debt securities may be difficult to sell quickly, particularly in credit risk funds in interest rate falling situations. 
• Duration Risk: The greater the average maturity of the fund’s portfolio, the more sensitive to interest rate changes its NAV will be.

Debt mutual fund taxation can be done in two ways: 

• Capital Gain Tax 
• Income Distribution cum Capital Withdrawal (IDCW)

Capital Gain Tax on Debt Mutual Funds

Capital gain is the profit earned when you redeem or sell your debt mutual fund units. It is broadly calculated as the difference between the sale/redemption value and the purchase value of the fund.

The tax treatment of debt mutual funds changed significantly from 1 April 2023 with the introduction of Section 50AA of the Income-tax Act, 1961.

Tax Rules Before 1 April 2023

Before this change, debt mutual fund investments were generally classified based on the holding period:

• Held for 36 months or less: The gain was treated as Short-Term Capital Gain (STCG) and taxed according to the investor's applicable income-tax slab rate.
• Held for more than 36 months: The gain was treated as Long-Term Capital Gain (LTCG) and taxed at 20% after indexation. Indexation allowed investors to adjust the purchase cost for inflation, potentially reducing the taxable capital gain.

Tax Rules From 1 April 2023

For specified mutual funds covered under Section 50AA and acquired on or after 1 April 2023, the gains are treated as STCG irrespective of the holding period.

This means that even if you hold the investment for several years, the gains are generally taxed at your applicable income-tax slab rate. The earlier LTCG treatment and indexation benefits are not available for such investments.

Example: Suppose you invest ₹5 lakh in a debt mutual fund covered under Section 50AA and later redeem it for ₹5.75 lakh.

Capital Gain = ₹5.75 lakh − ₹5 lakh = ₹75,000

If you fall in the 30% tax slab, the ₹75,000 gain will generally be taxed at your applicable slab rate, along with applicable surcharge and cess.

Note: Tax treatment can vary depending on the type of mutual fund, date of investment and applicable tax rules. Always check the scheme's tax classification and the latest income-tax provisions before investing or redeeming.

Dividend Taxation on Debt Mutual Funds 

In mutual funds, dividends are referred to as Income Distribution cum Capital Withdrawal (IDCW). An IDCW option may provide payouts at regular intervals, such as monthly or quarterly, but these payments are not guaranteed. The amount and frequency depend on the fund's performance and available distributable surplus.

When an IDCW is paid, it is treated as income in the hands of the investor and taxed according to their applicable income-tax slab rate. The fund house does not pay dividend distribution tax separately on your behalf.

For resident investors, 10% TDS generally applies when the aggregate IDCW paid or credited during a financial year exceeds ₹10,000, subject to applicable rules. The TDS deducted is adjusted against your final tax liability.

Example: Suppose you receive ₹20,000 as IDCW during a financial year. If 10% TDS applies, ₹2,000 will be deducted and you will receive ₹18,000. If you fall in the 20% tax slab, your total tax liability on the ₹20,000 IDCW would be ₹4,000 (before cess and other applicable provisions). Since ₹2,000 has already been deducted as TDS, the remaining ₹2,000 would generally be payable while filing your tax return.

Which Funds Are Still Taxed as Equity

Not all funds discussed under the broader debt/hybrid category are taxed as debt funds. Equity-oriented funds, including certain hybrid funds that invest at least 65% of their total proceeds in equity shares of domestic companies, continue to get equity mutual fund tax treatment.

Arbitrage funds are another example. Although they generally carry lower risk than traditional equity funds, they qualify as equity-oriented funds if they meet the prescribed equity investment criteria and are therefore taxed under the equity mutual fund rules.

So, before investing, check the fund's tax classification and portfolio allocation, rather than judging its tax treatment only by its name or category.

SIP Taxation in Debt Funds

Each SIP installment in a debt mutual fund is treated as a separate investment for taxation. When you redeem units, the capital gain is calculated separately for the units purchased through each installment. For investments covered under Section 50AA, gains are treated as short-term capital gains and taxed at your applicable slab rate, irrespective of how long each installment was held.

Example: If you invest ₹5,000 every month through a SIP, the units bought in January, February, March, etc. are considered separate investments. When you redeem, the tax calculation is based on the purchase cost and redemption value of the units being sold.