What are debt funds? Who should invest in them? Here's all you need to know

Selecting the best investment for your money is important. You need an option that is safe, yields good returns, and offers flexibility for your financial needs. According to Aditya Birla Capital For many Indian investors, debt mutual funds are the ideal choice.

What is a debt fund?

A debt fund is a type of mutual fund that places your money in fixed-income instruments such as government securities, corporate bonds, and money market instruments. These are generally safer than equity funds.

How do debt funds work?

Debt funds invest in various fixed-income instruments including bonds, treasury bills, and commercial paper. These are issued by governments, public sector units, banks, non-banking financial companies, and corporates.

How do debt funds generate returns in India?

Debt funds generate returns primarily through:

1. Coupon or accrual income: This is the interest income earned from the portfolio's holdings. The interest rate depends on the credit rating and the duration of the instruments.

2. Capital gains/losses: Changes in interest rates can cause bond prices to rise or fall, which affects the fund. Longer maturities mean higher sensitivity to interest rate changes.

Types of debt funds

Debt funds can be categorised into:

1. Short duration funds: These focus on short-term instruments, leading to stable returns with minimal capital gains or losses.

   

2. Long duration funds: These funds invest in long-term bonds, which can yield significant returns from capital gains when interest rates drop. However, they also carry a higher risk.

Strategies employed by fund managers

Aditya Birla Capital provides strategies that fund managers use to optimise returns within acceptable risk levels:

1. Varying average portfolio maturity: Managers adjust the duration of portfolio holdings based on interest rate movements to maximise profits or minimise losses.

2. Managing credit exposure: Managers select bonds with varying levels of risk to balance the potential for higher earnings against possible losses.

Who should consider investing in debt funds?

1. Retirees and conservative investors: For those seeking steady income with low volatility, debt funds are an excellent alternative to bank fixed deposits.

2. Aggressive investors using STPs: Equity investors might use systematic transfer plans to initially invest in debt funds, then gradually move money to equity funds to benefit from rupee cost averaging.

3. Investors with temporary surplus funds: Instead of leaving surplus funds idle, investing in debt funds can provide better returns with controlled risk.

4. Investors seeking duration-based investments: Based on their financial goals and time horizons, investors can choose from various debt fund types like liquid, ultra-short, short, medium, or long duration funds.

Risks involved with debt funds

Investing in debt funds involves several risks:

1. Interest rate risk: Use metrics like average maturity and modified duration to understand how rate changes might impact the fund.

2. Credit profile: Analyse the credit ratings and sector exposures of the fund’s holdings to assess credit risks.

3. Portfolio holdings and turnover: Examine the composition and turnover of the fund to evaluate potential performance.

4. Risk-return tradeoff: Match your risk tolerance and return expectations with the appropriate debt fund category.

Taxation of debt funds in India

Debt funds are subject to two types of taxes:

1. Dividend income: Taxed according to your income tax slab.

Imagine you receive Rs 50,000 in dividends from your debt fund investments in a financial year. Suppose your total annual income (including this dividend) puts you in the 30% income tax slab. The Rs 50,000 dividend income would be taxed at 30%. Therefore, you would pay Rs 15,000 as tax on your dividend income.

2. Capital Gains
 

— Short-term (≤ 3 years): Taxed at your income tax slab rate.

For instance: You invested Rs 1,00,000 in a debt fund and sold your investment after 2 years for Rs 1,20,000. The profit of Rs 20,000 is considered a short-term capital gain because the investment was held for less than 3 years. If your total income places you in the 20% tax bracket, this Rs 20,000 would be taxed at 20%, amounting to Rs 4,000 in taxes.

— Long-term (> 3 years): Taxed at 20% with indexation benefits.

For instance: Let’s say you bought an investment in a debt fund for Rs 1,00,000 and sold it after 4 years for Rs 1,50,000. Your profit of Rs 50,000 is a long-term capital gain. However, in this period the cost of living, tracked by Cost Inflation Index (CII) increased. When you bought the investment, the CII was 200, and by the time you sold it, the CII had gone up to 250. This means that what you bought for Rs 1,00,000 is now considered to have a value of Rs 1,25,000 due to inflation.

So, if you sell the investment for Rs 1,50,000, your actual profit considering the effect of inflation is not the simple difference between Rs 1,50,000 and Rs 1,00,000. Instead, it's the difference between Rs 1,50,000 and the adjusted price of Rs 1,25,000, which is Rs 25,000.

This adjusted profit of Rs 25,000 is what you are taxed on, not the full Rs 50,000 by which the sale price exceeds your original purchase price. This means you pay less in taxes because the profit calculation takes into account the effect of inflation.