For many conservative investors, bank fixed deposits or FDs are their first choice. The love for bank FDs is easily understandable: easy-to-understand savings instrument, low risk and guaranteed return at maturity. But many investors are turning towards debt mutual funds, which have the potential to offer higher income tax-adjusted returns and provide more choices. Debt mutual funds primarily invest in a mix of debt or fixed income securities of different time horizons such as government securities, corporate bonds, treasury bills, and money market instruments.

Debt mutual fund returns

Remember that the returns from debt funds are market-linked. The return is based on interest income from underlying securities and capital appreciation/depreciation in the value of the securities due to changes in market dynamics.

Types of debt mutual funds

Debt funds are categorized into different types, depending on the underlying securities they hold. According to a new reclassification of mutual funds, capital markets regulator Sebi has notified 16 debt fund categories: overnight fund, liquid fund, ultra short duration fund, low duration fund, money market fund, short duration fund, medium duration fund, medium to long duration fund, long duration fund, dynamic bond, corporate bond fund, credit risk fund, banking and PSU fund, gilt fund, gilt fund with 10 year constant duration, and floater fund. The new categories define the tenure or type of security a fund can invest in, thus distinguishing debt mutual funds on the basis of risk. For example, liquid funds, according to Sebi’s new norms, can invest in only in money market securities with maturity of up to 91 days.

Interest rate risk

Bond prices generally rise or fall in response to interest rate changes or expectations of interest rate changes. Higher the maturity period of the bond, more sensitive they are to change in the interest rate. The interest rate risk can be minimized, say analysts, by opting for short-term funds or by matching your period of investment with what is called the maturity of debt funds.

Credit risks

This is the risk of default by the company whose security is bought by the debt fund manager. The credit risk can be minimised by opting for debt funds that invest in high-rated bonds or government securities.

Debt mutual fund taxation

Debt funds are taxed based on your holding period. If you redeem your investments before three years, the gains are treated as short-term capital gains. The gains are added to your income on the year of redemption and taxed in the applicable slab.

If you redeem after three years, they are treated as long-term capital gains. An investor will have to pay 20% tax on gains after indexation.

(Also read: Mint 30 | Best Mutual Funds to Invest In)

Indexation means adjustment of gains after taking inflation into consideration. Or in other words, the purchase price is adjusted for inflation. So you will be paying taxes on the returns over and above the inflation-adjusted initial investment.

This indexation benefit is not available on bank FDs. Thus, this is a big advantage of investing in debt mutual funds, if you are in a higher tax bracket and invest for more than three years. In bank FDs, the interest income is taxed according to your tax slab.

If you opt for the dividend option in debt mutual funds, any dividend declared by debt mutual funds is exempt from tax in the hands of investors. But the fund house is liable to pay a 28.84% dividend distribution tax on dividend paid to the individual investor.

How to choose a debt mutual fund

You should invest in a debt fund depending on the period for which you want to make the investment. Or in other words, match your investment horizon with that of the debt fund. For example, if you have a investment horizon of three months, liquid funds could be a less risky bet for you. Also, look at the modified duration, which is a measure of sensitivity of your debt fund to interest rate volatility. Fund houses disclose modified duration of in monthly fact sheets. Also, keep an eye on the exit load of the debt fund. Some funds levy a penalty for exiting before the minimum period.

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