Debt Funds: Meaning, Taxation, Benefits, Types etc

Debt-Funds

Debt funds

Debt, according to the Oxford Dictionary, means a sum of money that is owed or due. Debt instruments are those financial tools through which an entity can raise funds for its use. Companies borrow money from investors by issuing various types of debt instruments. Against each instrument, a fixed rate of interest is promised. For the company issuing the debt instrument the interest rate is the cost incurred in raising funds and for the investor buying the debt instruments, the rate is a return which is available on the money which they have lent. This is how debt instruments work. When it comes to debt funds, it means those types of mutual funds which invest in debt instruments to create returns for their investors. Lets understand in details

What are debt mutual funds?

Debt mutual funds are a type of mutual fund wherein the funds assets are invested in a variety of debt instruments. Each underlying asset of the mutual fund portfolio has a fixed rate of return. As such, the overall returns promised by the fund are stable and risk-free, though not guaranteed.

How do debt mutual funds work?

Here is a step-by-step guide as to how debt mutual funds work

  • Investors looking for safe and stable returns invest in debt funds
  • The investment of various investors is collected in a pool and then utilised by the fund manager to invest in different types of debt instruments.
  • The different types of debt instrument into which the mutual fund invests includes government securities, treasury bills, corporate bonds, money market instruments, commercial paper and other fixed income securities.
  • The securities which the fund managers choose for investment are chosen based on their credit rating. A high rated instrument has a higher probability of paying returns as well as the maturity amount when the investment period expires.
  • The investment depends on the interest rate regime of the economy. If the interest rates are falling, the fund manager of a debt fund invests in long-term debt instruments. If, on the other hand, the interest rates are rising, the fund manager invests in short-term debt instruments for maximum returns.
  • The returns of debt mutual funds are not fixed as they depend on the investment strategy of the fund manager. However, the returns lie in the range of 7% to 12%, are an average of the interest rates of the underlying assets of the portfolio and are also unaffected from market volatilities.

Benefits and application of debt mutual funds

Debt mutual funds are suitable for investors who are looking for wealth creation with minimal risks. Since debt funds invest in fixed interest securities, the risks associated with them is minimal and these mutual funds yield low but positive returns. Debt funds can, therefore, be chosen by investors looking for stable returns and the addition of a debt component in their financial portfolios.

Benefits of debt mutual funds are as follows

  • These funds try and optimise returns by diversifying the investment across a range of debt instruments
  • There are different types of debt mutual funds with varying asset allocations
  • There is short term as well as long term debt funds. Short term funds are suitable for investors who want liquidity and instant access to their invested funds. Long term debt funds, on the other hand, are suitable for those who want to invest over a long-term horizon.
  • Long term investment in debt funds also gives investors the benefit of indexation on their long term capital gains
  • Debt funds do not have interest rate risk and credit risk. They give returns even when the markets are volatile as the returns do not depend on the stock market performance. Thus, debt funds are safer investment options.
  • The returns provided by debt funds are better than those promised by bank fixed deposits, bank saving accounts and other fixed income investment instruments
  • Since debt funds primarily invest in high-rated debt instruments, the investments are secured and stable against interest and credit risks.

Types of debt funds

A variety of debt funds are available to invest in. These types include the following

  • Liquid or money market funds

These are the most liquid debt funds whose portfolio is invested in highly liquid money market instruments. The underlying assets of the fund have maturity tenure of one day and above. Investors who want to park their surplus funds for a short period of time choose liquid funds as the returns are better than those provided by bank saving accounts.

  • Ultra-short term funds

These debt funds also invest in liquid instruments with a short maturity period. However, unlike liquid funds, a part of ultra-short term debt funds is invested in long-term debt securities. The maturity period of the underlying assets of these funds can go up to 9 months or 12 months. Investors who are looking for better returns at a slightly increased risk can invest in ultra-short term debt funds.

  • Floating rate funds

Floating rate funds are those debt funds which invest in debt instruments having floating rate of interest. A floating rate of interest is that interest which changes with a change in the benchmark interest rate. If the macro interest rates are changing and the interest rate of the instrument is linked to such macro rates, an increase in the macro rates would increase the interest rate of the debt instrument and vice-versa. Floating rate funds are beneficial when the interest rates of debt are increasing in the market as these funds would promise better returns.

  • Short and medium term funds

These funds invest in instruments whose maturity lies between 1 year and 3 years. Thus, the maturity period of underlying assets is more than liquid and ultra-short term funds. Investors who want to invest for 9 to 12 months and have a low risk profile can invest in these types of debt funds.

  • Income funds

The underlying assets of these funds comprise of government bonds, money market instruments and corporate bonds. The assets have a high maturity period and suit investors with a long-term investment horizon. Investment in these funds should be made when the macro interest rates are expected to reduce so that investors can reap maximum returns.

  • Gilt funds

Debt funds which invest primarily in Government securities are called gilt funds. Securities issued by the Central and State Governments having maturity periods of 1 year and above are the preferred investment instrument for fund managers of gilt funds. There is a high level of interest rate risk in these funds which depends on the maturity profile of the portfolio.

  • Dynamic bond fund

These funds invest in a variety of debt instruments as well as money market instruments. There is no limit on the maturity period of the underlying assets, the limit of investment in a particular asset class or the type of investment instrument selected. Fund managers choose instruments of different maturity profiles and aim to generate the maximum returns for investors.

  • Corporate bond funds

Debt funds which invest primarily in debentures of companies and corporate bonds are called corporate bond funds. This fund is also called credit opportunities fund. The underlying assets of the funds have high rate of interest along with credit risk. Investors with a moderate risk appetite and having a medium to long term investment horizon can invest in these funds.

  • Fixed maturity plans (FMP)

Fixed maturity plans are close-ended debt funds with specified maturity tenure. The underlying assets also have a maturity period lesser than or coinciding with the maturity period of the fund. The fund managers buy and hold debt instruments for their entire maturity period after which the returns earned are paid back to the investors. These funds have no interest rate risk and are also tax saving in nature.

  • Hybrid debt funds

Hybrid funds are those funds which invest in a mix of debt and equity instruments promising better returns to investors. Hybrid funds have higher risk profiles than the above-mentioned debt funds and their returns are also better. There are three different types of hybrid funds which are as follows

  • Monthly Income Plans monthly income plans usually provide monthly incomes to investors from the returns generated from debt instruments and the dividends received through equity investments. The portfolio of monthly income plans usually consists of 70% to 95% debt investment and the remaining in equity instruments. The choice of receiving monthly incomes depends on the investor.
  • Capital protection oriented funds these are close-ended debt funds which invest in a mix of debt and equity instruments with a major proportion of the portfolio invested in debt. The asset allocation is done in such a manner that even after the equity investment gives a negative return, the fund would promise the invested capital after the investment period is over.
  • Multiple yield funds these are close-ended debt income funds. Income is generated through the returns promised by the debt component of the portfolio while the equity component ensures growth of the invested corpus.

Tax treatment of debt funds

Debt mutual funds have a different tax treatment than equity mutual funds because these funds invest in debt instruments and debt instruments attract capital gains differently. The tax implication in debt funds should be reviewed in two instances. One, when the investment into a fund is done and, two, when the fund is redeemed and a return is earned. So, lets understand the tax treatment of these instances separately

  • Tax implication when investing into debt funds

Investments done in debt mutual funds do not earn any tax relief. The investments are a part of your taxable income which is taxed as per your income tax slab rate.

  • Tax implication on redemption of debt funds

When debt funds are redeemed, there is a tax implication as the returns generated are called capital gains. However, the tax implication depends on the period after which the fund has been redeemed. There are two types of capital gains associated with redemption of debt mutual funds depending on the period of holding of the investment. These types are as follows

  • If the debt fund is redeemed within 36 months of investment, the returns earned from the investment are called short term capital gains
  • If the debt fund, on the other hand, is redeemed after 36 months of investment, the returns earned are called long term capital gains

The applicable tax would, therefore, depend on the type of capital gain and is as follows

In case of short term capital gain

In case of long term capital gain

The returns earned are taxed at your income tax slab rate

The returns are taxed @ 20% after factoring in indexation.

Indexation is when the earnings allowed to be adjusted for inflation during the period of holding the debt fund. Through indexation, the effective return earned, which is subject to tax, is reduced and the taxable amount is also low.

Example

Suppose you invest INR 1 lakh in a debt fund on 1st April 2019. Now, if you redeem your investment before 1st April, 2022, the returns that you earn would be called short term capital gains and would be taxed at your income tax slab rate. If, however, you redeem your investment any time after 1st April, 2022, long term capital gains would accrue and the tax rate would be 20% with the benefit of indexation.

Conclusion

Debt mutual funds are low risk investment options which give better returns when compared to investments in other fixed-income instruments. Moreover, there are a variety of debt funds to choose from and long term capital gains also enjoy indexation benefit. So, if you are a risk-averse investor with a short to long term investment horizon, you can invest in debt funds and enjoy stable returns.

FAQs

  • How does indexation work?

Indexation increases the cost of purchase after factoring in inflation to calculate the real value of the capital gains earned. To calculate the indexed cost of purchase, the following formula is used

(Cost Inflation Index (CII) of the year of sale / Cost Inflation Index (CII) of the year of purchase) *cost of purchasing the debt fund

This indexed cost is then deducted from the redemption price of the fund to find out the return generated and then the return is subjected to a tax of 20%.

  • Can I invest in multiple debt funds?

Yes, investors can invest in as many debt funds as they like.

  • What are close-ended debt funds?

Close-ended debt funds are those funds which have a minimum holding period and such funds cannot be redeemed before such minimum holding period.

  • Can I invest in debt funds through SIPs?

Yes, investments in debt funds can be done either through SIPs or through lump sum investments.

  • Do debt funds have any risk?

Yes, debt mutual funds have interest rate risks and credit risk.

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