Debt Funds – What Are Debt Funds, Types, Benefits & Investing in Debt Funds

When companies or entities issuing debt instruments want to raise funds, they ‘borrow’ from investors. In return, they promise a steady and regular interest. This is how debt instruments work in simple terms.

What is a Debt Fund?

Buying a debt instrument can be considered as lending money to the entity issuing the instrument. A debt fund invests in fixed-interest-generating securities such as corporate bonds, government securities, treasury bills, commercial paper, and other money market instruments. 

Mutual funds invest in debt funds mainly to earn low-risk, steady income and capital appreciation. The issuers of debt instruments will pre-decide the interest rate you will receive and the maturity date of those.

How do Debt Funds Work?

Debt funds invest in various securities based on their credit ratings. A security’s credit rating signifies the risk of default in disbursing the returns that the debt instrument issuer promised. A debt fund manager ensures that he invests in high-rated credit instruments. A higher credit rating means the entity is more likely to pay interest on the debt security regularly and repay the principal upon maturity.

Debt funds that invest in higher-rated securities are less volatile than those in low-rated securities. Additionally, maturity depends on the investment strategy of the fund manager and the overall interest rate regime in the economy. A falling interest rate regime encourages the fund manager to invest in long-term securities, while a rising interest rate regime encourages him to invest in short-term securities.

Who Should Invest in Debt Funds?

Debt funds try to optimise returns by investing across all securities classes, allowing them to earn decent returns. However, the returns are not guaranteed. Debt fund returns often fall in a predictable range, making them safer avenues for conservative investors. 

These debt funds are also suitable for people with both short-term and medium-term investment horizons. The short-term horizon is three months to one year, while the medium-term horizon is three to five years.

Short-Term Debt Funds:

For a short-term investor, debt funds like liquid funds may be ideal compared to keeping money in a savings bank account. Liquid funds offer higher returns in the 7%- 9% range and maintain liquidity to meet emergency requirements.

Medium-Term Debt Funds:

For a medium-term investor, debt funds like dynamic bond funds are ideal for riding the interest rate volatility. 
Compared to 5-year bank FDs, debt bond funds offer higher returns. If you want to earn a regular income from your investments, Monthly Income Plans may be a good option. Investing in debt funds is ideal for risk-averse investors as they invest in securities that offer interest at a predefined rate and return the principal invested fully upon maturity.

Types of Debt Funds

As mentioned above, many types of debt mutual funds suit diverse investors. The primary differentiating factor between debt funds is the maturity period of the instruments they invest in. Following are the different types of debt funds:

Dynamic Bond Funds:

As the name suggests, these are ‘dynamic’ funds. The fund manager keeps changing portfolio compositions according to the fluctuating interest rate regime. Dynamic bond funds have different average maturity periods as these funds take interest rate calls and invest in instruments of longer and shorter maturities.

Income Funds:

Income Funds take a call on the interest rates and invest predominantly in debt securities with extended maturities. This makes them more stable than dynamic bond funds. The average maturity of income funds is around five to six years.

Short-Term and Ultra Short-Term Debt Funds:

These debt funds invest in instruments with shorter maturities, ranging from one year to three years. Short-term funds are ideal for conservative investors as interest rate movements do not significantly affect them.

Liquid Funds:

Liquid funds invest in debt instruments with a maturity of not more than 91 days, making them almost risk-free. They have rarely seen negative returns. Liquid funds are better than savings bank accounts as they provide similar liquidity with higher yields. Many mutual fund companies offer instant redemption on liquid fund investments through unique debit cards.

Gilt Funds:

Gilt Funds invests only in high–rated government securities with very low credit risk. Since the government seldom defaults on the loan it takes in the form of debt instruments, gilt funds are an ideal choice for risk-averse fixed-income investors.

Credit Opportunities Funds:

These are relatively newer debt funds. Unlike other debt funds, credit opportunities funds do not invest as per the maturities of debt instruments. These funds try to earn higher returns by taking a call on credit risks or holding lower-rated bonds with higher interest rates. Credit opportunities funds are relatively riskier debt funds.

Fixed Maturity Plans:

Fixed maturity plans (FMP) are closed-ended debt funds. These funds also invest in fixed-income securities such as corporate and government bonds. All FMPs have a fixed horizon for which your money will be locked. This horizon can be in months or years. However, you can invest only during the initial offer period. It is like a fixed deposit that can deliver superior, tax-efficient returns but does not guarantee high returns.

Things to Consider as an Investor

Risk:

Debt funds suffer from credit and interest rate risks, making them riskier than bank FDs. In credit risk, the fund manager may invest in low-credit-rated securities with a higher probability of default. In interest rate risk, bond prices may fall due to increased interest rates.

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 economy's overall interest rates, making them suitable for a falling interest rate regime.

Cost:

Debt fund managers charge a fee to manage your money, which is called an expense ratio. SEBI has mandated the upper limit of the expense ratio to be no more than 2.25% of the overall assets. Considering the lower returns generated by debt funds compared to equity funds, a long-term holding period would help recover the money forgone through the expense ratio.

Investment Horizon:

You may use liquid funds with a short-term investment horizon of three months to one year. Conversely, typical short-term bond fund tenures can be two to three years. Dynamic bond funds would be appropriate in case of an intermediate horizon of three to five years. Basically, the longer the horizon, the better the returns.

Financial Goals:

You can use debt funds as an alternative source of income to supplement your income from your salary. Additionally, budding investors can invest some portion in debt funds for liquidity. Retirees may invest the bulk of retirement benefits in a debt fund to receive a pension.

Taxation on Debt Funds

Investments Made On or After April 1, 2023

Tax Treatment: 

• All capital gains from debt mutual funds purchased on or after April 1, 2023, are considered as Short Term Capital Gains.
• These funds are not covered under section 111A and are, therefore, taxed at the investor's applicable income tax slab rate. 

Example: If you invest Rs. 1,00,000 in a debt fund on April 5, 2023, and redeem it for Rs. 1,20,000 in 2026, the Rs. 20,000 gain is added to your taxable income and taxed according to your slab rates.

Investments Made Before April 1, 2023

When Transfer Takes place before 23rd July 2024: 

Short-Term Capital Gains (STCG): 

Holding Period: If sold within 36 months (3 years) from the date of investment.

Tax Rate: Gains are added to your taxable income and taxed at your applicable income tax slab rate.

Long-Term Capital Gains (LTCG):

Holding Period: 

If held for more than 36 months.

Tax Rate:

Taxed at 20% with indexation benefit, which adjusts the purchase cost for inflation, reducing the taxable gain.

When Transfer Takes place on or after 23rd July 2024:

Short-Term Capital Gains (STCG): 

Holding Period: If sold within 24 months (2 years) from the date of investment.

Tax Rate: Gains are added to your taxable income and taxed at your applicable income tax slab rate.

Long-Term Capital Gains (LTCG):

Holding Period: 

If held for more than 24 months.

Tax Rate:

Taxed at 12.5% without indexation benefit.

Example:

Investment: Rs. 1,00,000 in June 2020, sold for Rs. 1,50,000 on 18th Feb 2024 (before July 23, 2024).

Indexed Cost (assuming inflation adjustment): Rs. 1,20,000.

Capital Gain: Rs. 30,000 (1,50,000 - 1,20,000).

Tax: 20% of Rs. 30,000 = Rs. 6,000.

If sold in 2025 (after July 23, 2024): Taxable Gain = Rs. 50,000 (without indexation benefit), Tax = 12.5% of Rs. 50,000 = Rs. 6,250.

Dividends

Dividends from debt mutual funds are taxed as "Income from Other Sources" and added to your total income, taxed at your applicable slab rate. This rule applies regardless of when the investment was made.

No TDS for Residents 

For Indian tax residents, no tax is deducted at source (TDS) when redeeming debt funds. You must compute and pay the tax liability yourself, including advance tax if applicable.

TDS for Non-Residents

 TDS applies at rates depending on the type of gain, subject to tax treaties.

Systematic Withdrawal Plan (SWP)

Each withdrawal is treated as a redemption, and the gains are taxed as per the rules above based on the investment date and holding period.

Impact of Changes

The removal of indexation for post-April 1, 2023 investments aligns debt fund taxation with normal slab rates, making them less tax-efficient for long-term holdings.

For pre-April 1, 2023 investments, the shift to a 20% flat rate without indexation (post-July 23, 2024) may increase the tax liability.

How to Invest in Debt Funds

Investing in Debt Funds is made paperless and hassle-free at ClearTax. The following steps will help you start your investment journey:

• Log on to cleartax.in
• Enter all requested details
• Enter the investment details (investment amount and maturity period)
• Complete your e-KYC, and it takes less not more than 5 minutes
• Invest in a suitable plan among the hand-picked debt funds

Conclusion

Debt funds offer very stable and predictable income, and they can be used as diversified, low-risk mutual funds in your portfolio. Debt funds are suitable for investors who are looking to hold some funds in debt exposure or want to get returns at very minimal risk.