How do Debt Funds work?
- Buying a debt instrument is similar to giving a loan to the issuing entity.
- The basic reason behind investing in debt funds is to earn interest income and capital appreciation.
- The interest that you earn on these debt securities is pre-decided along with the duration after which the debt security will mature.
- That’s why these securities are called ‘fixed-income’ securities because you know what you’re going to get out of them.
- Debt funds try to optimize returns by diversifying across different types of securities.
- This allows debt funds to earn decent returns, but there is no guarantee of returns.
- However, debt fund returns can be expected in a predictable range, which makes them safer avenues for conservative investors.
Who should Invest in Debt Funds?
Debt funds are ideal for investors who aim for regular income, but are risk-averse. Debt funds are less volatile and, hence, are less risky than equity funds. If you have been saving in traditional fixed income products like Bank Deposits, and looking for steady returns with low volatility, debt Mutual Funds could be a better option, as they help you achieve your financial goals in a more tax efficient manner and therefore earn better returns.
Things to Consider as an Investor
1. Risk
Debt funds suffer from credit risk and interest rate risk which make them riskier than bank FDs.
2. Return
Even though debt funds are fixed-income havens, they don’t offer guaranteed returns. The Net Asset Value (NAV)of a debt fund tends to fall with a rise in the overall interest rates in the economy. Hence, they are suitable for a falling interest rate regime.
3. Investment Horizon
You can invest in Debt funds for a range of investment horizons.
| Category | Ideal Period |
| Liquid Funds | 1 Day and Above |
| Ultra Short Term Funds | 0-3 Months |
| Short Term Funds | 3 -12 Months |
| Medium Term Funds | 1-3 Years |
| Credit Risk Funds | 3 Years and Above |
4. Financial Goals
Debt funds can be an ideal partner in your portfolio to achieve a variety of goals. You can use debt funds as an alternate source of income to supplement your income from salary. Additionally, budding investors can invest some portion in debt funds for purpose of liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive the pension.
5. Tax on Gains
When you invest in debt funds, you earn capital gains which are taxable. The rate of taxation is based on how long you stay invested in a debt fund called as the holding period. A capital gain made during a period of less than 3 years is known as a Short-term Capital Gain (STCG). A capital gain made over a period of 3 years or more is known as Long-term Capital Gains (LTCG). STCG from debt funds are also added to the investor’s income and taxed according to his income slab. TCG from debt funds is taxed at the rate of 20% after indexation