Debt mutual funds are a segment of mutual funds that primarily invest in fixed-income instruments such as corporate debt securities, money market instruments, and government and corporate bonds that offer capital appreciation.
These instruments offer fixed maturity dates and interest rates which ensures a higher degree of safety due to the lower credit risk because you are essentially lending money.According to the tenure of the securities held in the portfolio, the issuers of the securities, or their fund management strategies, debt funds can be divided into three categories:
Debt funds have the capacity to preserve capital and generate revenue. Most debt funds invest in a similar range of debt instruments and are suited to a conservative risk profile.
Debt funds are the preferred choice of conservative investors. They are also suitable for people with both short-term and medium-term investment horizons. Short-term ranges from three months to one year, while medium-term ranges from three years to five years.
Every investment possesses some degree of inherent risk. Debt funds share some risks that are common across all mutual funds, such as no guarantee or assured returns and loss of principal amount due to market volatility, interest rate fluctuations, changes in government policy, and political developments. Apart from these common factors, there are some risks that specifically relate to debt funds. These risks are a direct result of the volatility inherent in the debt market and include:
Investing in the right debt fund scheme differs from person to person. It is based on various factors – the most important being the ability to bear the risk and the willingness to take on the risk. Determining your own risk profile is essential in picking the right fund/scheme.
Other major factors include the financial goal and the time horizon for the investment. Here are some of the key factors to consider when selecting a debt fund right for your needs:
Short-term capital gains (if the units are sold before 36 months) in debt mutual funds are taxed as per the applicable tax rate of the investor. Therefore, if your tax rate is 30% then short-term capital gains tax on debt funds is 30% + 4% cess. Long-term capital gains (if the units are sold after 36 months) in the debt fund are taxed at 20% with indexation. Also, Dividends received by investors are added to their overall income and taxed at the income tax slab rate they fall under.
Debt funds are considered low-risk investments because you are essentially lending money. However, There are some risks to keep in mind. They are:
Overnight funds and liquid funds are the safest because they are short-term which reduces the interest rate risk and credit risk that these funds can take. Overnight funds mature in 1-day. Liquid funds can only invest in debt and money market securities that mature in or up to 91 days.
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