What are Debt Mutual Funds in India and how they work?

Debt funds are mutual fund schemes which invest in fixed income securities like Government bonds,corporate bonds and money market securities like commercial papers (CPs), certificates of deposits (CDs) etc. The main objective of debt mutual funds is to generate income for investors over the investment period which can be of few days to many years.

There are mainly three types of debt mutual funds in India –

  1. Short term debt funds which invest in fixed income securities with shorter maturities. See return of short term debt mutual funds
  1. Long term debt funds, also known as Income Funds which invest in securities with longer maturities. See return of income funds
  1. Medium term debt funds invest in securities with intermediate maturities. See return of medium term debt funds

Unlike bank fixed deposits or Post Office small savings schemes which offer assured returns, debt mutual funds are subject to debt market risks and therefore,like any other mutual fund, debt funds can also not give assured returns. In fact, in mutual fund parlance there is no concept of ‘assured or fixed returns’.

Debt Mutual Funds have mainly two types of risk – interest rate risk and credit risk.

Interest rate risk is related to the maturity of the bond that the debt mutual fund scheme may held in its portfolio. Bonds which mature later have higher interest rate sensitivity (both on upside and downside) compared to bonds which mature earlier. If interest rates decline, long term debt mutual funds can give much higher returns than short term debt mutual funds. On the other hand, if interest rates rise, then short term debt mutual funds will outperform long term debt mutual funds.

Credit risk refers to the risk of default of interest and principal payment by the bond issuer. If credit risk increases (i.e. credit rating worsens), then bond prices will fall; if credit risk decreases (i.e. credit rating improves), then the bond prices will rise. Investors should know that, bonds with lower credit rating will give higher yields to investors, but the risk is also higher.

The risk profile of debt mutual funds ranges from low to moderate, depending on the fund categories. Debt mutual funds provide good investment solutions to investors for a variety of investment goals, tenures and interest rate scenarios. Investors should understand the risk factors of debt funds and select schemes based on their investment goals and tenures.

Read what different types of debt mutual funds in India are Taxation of Debt Mutual Funds

Debt mutual funds enjoy tax advantage over a 3 year plus investment horizon compared to traditional fixed income investments like bank fixed deposits and Post Office small saving schemes. Capital gains from debt mutual funds held for less than 3 years are taxed as per the income tax rates of the investors. Capital gains from debt mutual funds held for more than 3 years are taxed at 20% after allowing for indexation benefits.

See how you can earn more from debt mutual funds than bank deposits

Dividends paid by debt mutual fund schemes are tax free in the hands of the investors but the scheme has to pay dividend distribution tax (DDT) at the rate of 28.84% for individuals and Hindu Undivided Families (HUF) before distributing dividends to investors. Applicable dividend distribution tax rate for companies investing in debt funds is 34.608%.

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