Why Debt Mutual Funds Are Worth Investing In

Debt mutual funds are a type of mutual fund that invests in fixed-income instruments such as corporate and government bonds, corporate debt securities, and money market instruments. They are ideal for investors seeking a stable and predictable source of income and are known for their liquidity, allowing investors to buy and sell units easily. The main sources of returns for debt funds are interest income and capital appreciation. Debt funds are considered less risky than equity funds and are a good option for investors who want to preserve their capital while earning better post-tax returns than FDs. However, it's important to note that debt funds are not entirely risk-free and carry interest rate risk and credit risk.

Debt funds vs fixed deposits

Debt funds and fixed deposits (FDs) are both investment options for those who want to put their money into low-risk ventures. However, there are some key differences between the two.

Fixed Deposits

Fixed deposits are a type of savings account offered by banks and other financial institutions. They are typically deemed low-risk investments suitable for those who want to earn a fixed return on their savings. FDs offer guaranteed returns at reasonable rates, and interest is paid at a fixed rate. In the case of FDs, the bank provides assurance of capital safety, and they are thought to be risk-free investments. However, in the rare case of a bank default, investors may lose some of their principal and interest.

Debt Funds

Debt funds, on the other hand, are mutual funds that invest in fixed-income securities such as bonds and debentures. They offer the potential for higher returns than FDs but also carry more risk. The returns on debt funds are not fixed and are subject to market fluctuations. Debt funds are also subject to market risks, and there is no assurance of capital safety. There are two types of risk associated with debt funds: interest rate risk and credit risk. Interest rate risk depends on the duration profiles of the funds, while credit risk depends on the credit ratings of the underlying securities.

Both debt funds and FDs are highly liquid, with no lock-in period. However, some banks may charge penalties for early FD withdrawals, and debt funds may have exit loads. FDs pay compound interest at a fixed rate, while debt fund returns depend on the overall interest rate movement. Debt funds do not give assured returns, and historical data suggests that they have usually outperformed FDs of similar tenures.

When it comes to taxation, interest on FDs is taxed during the tenure of the investment and on maturity, according to the investor's income tax rate. Debt funds, on the other hand, enjoy a tax advantage over FDs, especially for investors in the higher tax brackets. Short-term capital gains in debt funds are taxed like FDs, but long-term capital gains are taxed at 20% with indexation benefits.

In summary, if capital safety and assured returns are paramount, then FDs are the better option. However, if you are willing to take on slightly more risk, debt funds can provide potentially superior risk-adjusted returns and taxation benefits.

Capital gains and interest earnings

Debt mutual funds are a type of mutual fund scheme that invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. They are ideal for investors seeking a stable and predictable source of income with relatively low risk.

Mutual funds distribute the dividends on stocks and interest on bonds held in their portfolio. Funds often give investors the choice between receiving a check for distributions or reinvesting earnings for additional shares in the mutual fund.

Capital gains are profits earned when you redeem your debt mutual fund holdings. If the net asset value (NAV) of the units at the time of redemption is higher than the NAV at the time of purchase, you earn profits that are taxed as capital gains.

Dividends from debt funds were previously tax-free, but since the abolition of the Dividend Distribution Tax (DDT) in Budget 2020, they are now added to the total income of investors and taxed according to their applicable slab rate.

Capital gains from debt funds held for up to 36 months are considered short-term capital gains (STCG) and are taxed according to the investor's income tax slab rate. Gains from debt funds held for longer than 36 months are considered long-term capital gains (LTCG) and are taxed at a flat rate of 12.5% without any indexation benefits.

It is important to note that the tax treatment of capital gains changed in the Union Budget 2024. The holding period required to qualify for LTCG treatment was reduced from 36 months to 24 months. Additionally, the LTCG tax rate for all assets, except debt mutual funds, was changed to 12.5% in the July 2024 budget.

When dividend and capital gain distributions are made, the NAV per share of the fund drops by the amount distributed. However, the shareholder has not lost money due to this decline in the NAV. They have either received the distribution in cash or reinvested the money in additional fund shares purchased at the lower adjusted NAV.

Example of capital gains calculation

Suppose you bought $10,000 worth of an equity mutual fund on January 1, 2019. Over the next five years, the fund paid distributions totaling $3,000, which you reinvested in the fund account and included on your tax returns. When you sold all your shares on July 31, 2024, you received $19,000, which is $9,000 above your original investment. However, you would not pay taxes on the entire $9,000 since you had already been taxed on the $3,000 of distributions over the previous five years. You would only include $6,000 as your capital gain on your 2024 tax return.

Debt fund risks

Debt mutual funds are considered less risky than equity funds, but they are not risk-free. Here are some key risks associated with debt mutual funds:

Interest Rate Risk

Interest rate risk is one of the primary risks in debt mutual funds. This risk arises due to the inverse relationship between interest rates and the prices of debt instruments. When interest rates change, it affects the value of the fund's underlying debt securities. For example, if interest rates increase, the value of existing bonds with lower interest rates will decrease, leading to a potential loss for the fund. Conversely, if interest rates decrease, the value of bonds with higher interest rates will increase, resulting in a gain for the fund. This risk is particularly significant for long-duration funds, which are more sensitive to interest rate changes.

Credit Risk

Credit risk is another significant concern in debt mutual funds. This risk arises from the possibility of the borrower defaulting on interest or principal payments. If the borrower fails to make payments, it can negatively impact the fund's performance and lead to losses for investors. Credit risk can affect even liquid funds, as seen in the case of DHFL and IL&FS defaults. To mitigate this risk, investors should consider investing in funds that lend to highly-rated corporates with low default risk, such as those with AAA ratings.

Liquidity Risk

Liquidity risk is the risk that the fund house may not have sufficient liquidity to meet redemption requests from investors. This risk is inherent in the nature of debt funds, as they invest in fixed-income instruments with specific maturity dates. If a large number of investors simultaneously request redemptions, the fund may struggle to liquidate its holdings quickly enough to meet these demands. This risk is particularly relevant for funds with longer maturity periods or those investing in lower-rated bonds.

Other Risks

In addition to the above, debt mutual funds also face other risks, such as:

• Market Risk: The value of the securities held by the fund may decline due to market conditions or economic factors.
• Management Risk: Poor investment decisions by the fund's management team can negatively impact returns.
• Inflation Risk: Inflation can erode the purchasing power of the fund's returns over time.
• Reinvestment Risk: The fund may struggle to reinvest proceeds from maturing securities at the same or higher interest rates, leading to lower returns.

Taxation of debt funds

Debt funds are a type of mutual fund scheme that invests in fixed-income instruments, such as corporate and government bonds, corporate debt securities, and money market instruments. The returns from debt funds are generated through interest income and capital appreciation, and their taxation depends on the holding period.

As per the latest income tax rules in India (as of April 2023), long-term and short-term capital gains (LTCG and STCG) arising from mutual funds are taxed according to your income tax slab. There is no indexation benefit for debt funds.

If you remain invested in debt mutual funds for up to 3 years and make capital gains through redemption, these gains are considered STCG and are added to your income and taxed according to your income slab.

On the other hand, if you have invested for over 3 years and earned gains, these are classified as LTCG and are taxed at a flat rate of 20% with indexation benefits.

Debt funds are taxed differently for investments made before April 1, 2023. For example, if you had invested in debt mutual funds for up to 3 years and made capital gains, these would be taxed at a flat rate of 15% (with indexation benefits) or 30% (without indexation benefits).

Debt funds offer a range of investment options along the spectrum of maturity and credit risk. They are also very liquid and can be redeemed easily, usually within one or two working days. There is no lock-in period, and while some funds may impose a small exit load for early withdrawal, there are generally no penalties for withdrawing a mutual fund investment.

Who should invest in debt funds

Debt funds are a type of mutual fund that invests in fixed-income securities, such as bonds, debt, T-bills, and other money market instruments. They are known for providing stable returns with less volatility compared to equity funds. While they may generate lower returns than equity funds, debt funds are an essential component of a well-diversified and balanced investment portfolio.

So, who should invest in debt funds? Here are some key considerations:

• Risk Tolerance and Investment Goals: Debt funds are ideal for conservative investors who seek capital appreciation with low risk. They are less sensitive to market movements, making them a good option for those uncomfortable with the volatility associated with equity investing. If you are a new investor or prefer a more conservative approach, debt funds can provide stable returns without the fear of significant losses due to market crashes.
• Age and Investment Horizon: The allocation to debt funds should generally increase with age. Senior citizens may want to allocate a larger portion of their portfolio to debt funds compared to younger investors. Debt funds are also suitable for short-term goals, providing higher interest rates than bank deposits.
• Regular Income: Debt funds that invest in high-quality bonds or keep durations low are a good choice for investors seeking regular income, such as retired individuals. They provide steady returns with less volatility.
• Alternative to Fixed Deposits: Debt funds can be a viable alternative to fixed deposits for conservative or first-time mutual fund investors. They offer liquidity and flexibility of withdrawal, and the potential for higher returns, especially when interest rates are declining.
• Bearish Market Strategy: Even aggressive equity investors can benefit from combining debt funds with a Systematic Transfer Plan (STP). During a bearish market, an STP from a debt fund to an equity fund can minimise average costs.
• Emergency Funds: Debt funds, particularly liquid and ultra-short-duration funds, are suitable for parking emergency funds. They offer better returns than savings accounts while maintaining low risk.
• Tax Considerations: While the tax advantages of debt funds have recently changed, they may still offer some tax benefits over fixed deposits. Debt funds are taxed only when you redeem the units, allowing for better compounding of returns. Additionally, there is no Tax Deducted at Source (TDS) on debt funds.

In summary, debt funds are suitable for investors seeking stable returns, low volatility, and regular income. They are particularly attractive to conservative investors, first-time investors, those with short-term goals, and individuals looking for alternatives to fixed deposits. However, it is important to remember that debt funds carry interest rate risk and credit risk, and there are no guaranteed returns. Investors should carefully consider their risk tolerance, investment goals, and time horizon before investing in debt funds.

Frequently asked questions