Debt Mutual Funds

What is Debt Fund?

A debt fund is a mutual fund scheme that invests in fixed income instruments, such as Corporate and Government Bonds, corporate debt securities, and money market instruments etc. that offer capital appreciation. Debt funds are also referred to as Income Funds or Bond Funds.

Who should invest in a Debt Fund?

Debt funds are ideal for investors who want regular income, but are risk-averse. Debt funds are less volatile and, hence, are less risky than equity funds. If you have been saving in traditional fixed income products like Term Deposits, and looking for steady returns with low volatility, debt mutual funds could be a better option, as they help you achieve your financial goals in a more tax efficient manner and therefore earn better returns.

How Debt Funds Work?

Debt funds invest in either listed or unlisted debt instruments, such as Corporate and Government Bonds at a certain price and later sell them at a margin. The difference between the cost and sale price accounts for the appreciation or depreciation in the fund’s net asset value (NAV). Debt funds also receive periodic interest from the underlying debt instruments in which they invest. In terms of return, debt funds that earn regular interest from the fixed income instruments during the fund’s tenure are similar to bank fixed deposits that earn interest. This interest income gets added to a debt fund on a daily basis. If the interest payment is received, say, once every year, it is divided by 365 and the debt fund’s NAV goes up daily by this small amount. Thus, a debt scheme’s NAV also depends on the interest rates of its underlying assets and also on any upgrade or downgrade in the credit rating of its holdings.

Market prices of debt securities change with movements in interest rates. Let’s assume, your debt fund owns a security that yields 10 % interest. If the interest rate in the economy falls, new instruments issued in the market would offer this lower rate. To match this lower rate, there would be an increase in the prices your fund’s underlying instruments as they have a higher coupon (interest) rate. As a result of the increase in the debt instrument’s value, your fund’s NAV, too, would increase.

Debt Mutual Funds Vs Fixed Deposits

Currently, there are two most popular methods of investing – Fixed Deposits & Debt Mutual Funds. These two methods of investment are normally do meet primary goals of an investor which are low risk investment avenue, seek returns in 5 years & to gain atleast 8% to 9% of rate of returns. But then there are certain aspects like benefits, features that differentiate them & the difference in the way they work can be of advantage or disadvantage depending on the type of investor one is.

Debt Mutual Funds Bank Fixed Deposits
Return is market dependant hence may vary as per the prevailing conditions Returns are fixed & not subject to any market fluctuations
There is a scope for capital gain & loss In FDs, there is no scope for capital gain or loss
Tax liability only arises when the investor sells the units of the mutual fund These attract higher tax rate. Tax is also applicable on accrued income which is due to be received
There is no concept of premature withdrawal Penalty is levied on premature withdrawal
Are more tax efficient if the investment horizon is for more than 3 years Interest income is taxed. If the interest paid exceeds Rs. 10,000
Can liquefy investments quickly Funds are locked in until maturity date
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