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Chapter 3.11: What is a debt fund?

Summary:

  • A debt fund is a kind of mutual fund that invests in debt instruments.
  • These funds usually have low risk, and therefore, low returns and are considered to be safe investments.
  • Debt funds may invest in one asset class or across several asset categories.

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What is a debt fund?

It is a fund that invests in debt instruments like bonds, government securities, and debentures. It provides returns on your investment at a fixed interest rate over a fixed period of time.

Everyone seems to be talking about mutual funds these days. If you haven’t ventured into such investment, let us decode things for you.

Simply put, a mutual fund is a pool of money. Investors put their money in the fund and the fund house invests this in stocks and bonds. These may be stocks and bonds of private companies or those issued by the government. When these companies or the government make a profit, the fund generates profits in return. The money it makes is distributed to the investors. Mutual funds may be categorised based on what they invest in. The three common categories are equity funds, debt funds, and hybrid funds.

How does a debt fund work?

Debt funds are funds that lend money to companies, banks, or the government. In other words, these funds invest in stocks, bonds, and debentures, which act as a borrowing mechanism for companies, banks, or the government. They take money from the market and invest it in infrastructure or growth of the business.

The money from the fund is invested to reap bigger profits. The investors get their money back over a period of time. They also earn interest on the amount they invest. Both the rate of interest and the maturity period are fixed.

Here, the maturity period is the time at which the principal amount is returned to the investor.

(Read more: How mutual funds work?)

Basic features of a debt fund

Regular pay-out: Usually, you get regular interest payments when you invest in a debt fund. Many people prefer it for the regularity of income.

Low risk: Debt funds pose low risk. The interest amount is fixed. The principal you invest is returned to you at a fixed time as well. Unless there is a huge upheaval in the market, debt funds are safe investments.

Low return: Low risk also means low returns. Debt funds are ideal for people who value safety over high returns.

Flexible time period: Debt funds may have long or short maturity periods. Accordingly, they are divided into long-term and short-term debt funds.

Range of investments: Debt funds may invest in one single type of debt instrument. Or, they may choose to invest in several assets like securities or bonds. This choice tells you about the risk involved. For instance, gilt funds are debt funds that lend money to the government by buying government securities. Since the government is unlikely to default, these funds pose a low risk to the investor.

How to invest in debt funds

Approach your bank or a fund house of your choice. For first-time investors, investing through a systematic investment plan (SIP) is a better idea. You can invest a small amount each month.

(Read more: How to start an SIP investment?)

Also, debt funds are very liquid. You can withdraw your investment when you want. However, you may have to pay a penalty. This is termed as an exit load.

Before you decide on the investment duration, find out about the tax liabilities. There is no tax deducted at source (TDS) on debt funds.

How to choose the right one

When it comes to investment, there is no one-size-fits-all scheme. You have to look at your own priorities and the fund’s performance. Here is an overview of the broad aspects that you should consider before investing your money in a debt fund.

Maturity period: Can you keep your money invested for three to five years or more? Or, do you want to invest for only a few months?

Risk appetite: Usually high returns mean high risk. Can you bear a loss if the market crashes?

Past performance of fund: While no two years are identical, look for a track record of good returns.

Expense ratio: The expense you incur on the fund offsets the returns you get. So, do a thorough calculation.

(Read more: How to choose a mutual fund scheme?)

Tax implications of debt funds

For a debt fund, the holding period is three years. That is, you must stay invested for three years.

When you sell your fund before three years, you have to pay short-term capital gains tax. This tax amount will depend on your income tax slab. When you sell your fund before three years, you have to pay short-term capital gains tax. This tax amount will depend on your income tax slab.

When you sell your fund after three years, long-term capital gains tax may accrue. This will be a flat rate of 20%. But there will be indexation benefits.

Indexation benefits mean that your income will be adjusted to inflation at the time. Tax will be imposed on this adjusted amount.

It may help to calculate what investment horizon will help you save on taxes.

Conclusion:

A debt fund is a good instrument to start with. But everyone has different liabilities and priorities. Start by assessing your risk appetite. See how long you can stay invested without liquidating the investment. See what amount you are comfortable with investing in the debt fund. Calculate your tax liabilities as well.

Once you have the figures in place, do your research on the debt fund schemes available in the market. Choose the fund that is right for you.

WHAT NEXT?

We are almost at the end. Before you start investing in mutual funds, there are a few more important points to keep in mind like taxation. This can affect your total financial returns. To know about these factors, Click here

Why Capital gains report?
  • Snapshot of profit/loss
  • Reflects performance of your portfolio
  • Helps compute taxes
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