Many of us use loans to buy a house or a car. Corporations and the government also use loans for various purposes. These loans are fixed-income instruments for investors as they generate fixed income over time. Debt mutual funds invest in fixed-income instruments like bonds and money market instruments. Let’s discuss them in more detail.
To understand debt funds, let us understand what we mean by Debt.
We often make big purchases like buying a house or a car, but we may not always have enough money to pay for them outright. In such cases, we approach a bank and opt for a loan for the remaining amount. The bank lends us money based on certain conditions, and we pay back the loan along with interest in regular instalments known as Equated Monthly Instalments (EMIs).
Similarly, corporations and governments need money for their functioning and expansion. They have two options to raise that money:
Many times, they choose to borrow it from investors by issuing bonds. The bond is like a promise to return the principal amount after a certain period and make periodic payments of interest (the fixed income!).
The funds which invest in such bonds from government and corporations are known as debt funds. They are less risky compared to equity mutual funds. They have a low expense ratio and generate stable returns. But as the risk level is low, return potential is also low.
Debt funds are best suited for investors who have a low-risk appetite and are looking for regular income and fixed returns. People looking to park their money for a short duration or investors looking to invest their emergency funds can also consider investing in debt funds. This investment option can also be a suitable choice for those who want to avoid the high volatility of stock markets. This makes it a suitable choice for post-retirement investments.
Further, even equity investors should consider some allocation to debt funds purely from a diversification point of view.
In the case of debt funds, the gains are taxed at the investor's tax slab. Previously, if the holding period was more than 36 months, it was treated as Long-Term Capital Gains (LTCG). LTCG for all funds other than equity funds was taxed at 20% with an indexation benefit.
But after the recent amendment in the taxation policy (effective April 1st, 2023), investors in debt mutual funds won’t get the indexation benefit, and their gains will be added to the taxable income of the investor and taxed accordingly. This is applicable to debt funds that invest more than 65% of the pooled money in debt assets.
If you are an investor with a low-risk appetite and in turn are happy with moderate returns, you can consider investing in a debt mutual fund. Aggressive investors can also consider this option to diversify their portfolios.
As per the SEBI guidelines, Debt funds are divided into 16 different types. You can find the complete list here.