What are Debt Mutual Funds | Types of Debt Mutual Funds | Debt Mutual Funds Taxation |

Debt mutual funds are investment vehicles that pool money from multiple investors to invest primarily in fixed-income securities such as government and corporate bonds, treasury bills, commercial paper, and other money market instruments. These funds are managed by professional fund managers who allocate the pooled funds across various debt instruments based on the fund’s objectives, investment horizon, and risk profile.

These funds are categorized based on the duration of the underlying securities they invest in. For instance, there are short-term debt funds like liquid funds, ultra-short duration funds, low duration funds, and short duration funds, each with varying investment horizons and risk profiles. Additionally, there are medium and long-term debt funds with longer maturity profiles, such as medium duration funds, long duration funds, and gilt funds.

Debt mutual funds provide investors with an opportunity to earn returns through interest income and capital appreciation while managing risks associated with fluctuations in interest rates and credit risks associated with the issuers of the underlying securities. They offer varying levels of risk and returns, catering to different investor preferences for stability, income generation, and potential growth within the fixed-income space. These funds also offer liquidity through features like easy redemption, making them suitable for investors with varying investment goals and time horizons.

Types of Debt Mutual Funds

Overnight Debt Mutual Funds

Overnight mutual funds are a type of mutual fund scheme that invests in securities with a very short-term maturity, typically within one day. These funds primarily invest in instruments like government securities, treasury bills, or other money market instruments with a maturity of one day. They aim to provide investors with a safe and liquid investment option while offering potentially higher returns than traditional savings accounts. Since they invest in very short-term instruments, they are considered to have minimal interest rate risk and can be suitable for investors seeking low-risk investment options with quick liquidity.

Liquid Debt Mutual Funds

Liquid mutual funds are investment vehicles that primarily invest in short-term debt instruments such as Treasury Bills, Certificates of Deposit, and commercial paper with very short maturities, typically up to 91 days. These funds aim to offer investors a high level of liquidity and safety with relatively stable returns. They are well-suited for parking surplus funds for the short term, offering easy redemption and generally providing slightly higher returns compared to traditional savings accounts while maintaining low levels of risk due to the short maturity of their underlying securities.

Ultra Short Duration Debt Mutual Funds

Ultra Short Duration Mutual Funds are a category of debt mutual funds that invest in fixed-income securities with slightly longer maturities than liquid funds but shorter durations than other debt funds. They typically invest in instruments such as government securities, corporate bonds, and money market instruments with durations ranging from 3 months to 6 months. These funds aim to generate slightly higher returns than liquid funds while maintaining relatively low interest rate risk, making them suitable for investors seeking a balance between higher returns and minimal volatility in the short term.

Low Duration Debt Mutual Funds

Low Duration Mutual Funds belong to the category of debt mutual funds that primarily invest in fixed-income securities such as government securities, corporate bonds, and money market instruments. These funds have a portfolio duration longer than liquid and ultra-short duration funds but shorter than medium duration funds, typically ranging from six months to one year. They aim to provide investors with slightly higher returns compared to liquid or ultra-short duration funds while still managing interest rate risks within a moderate range, making them suitable for investors looking for a balance between returns and risk in the short to medium term.

Short Term Mutual Funds

Short Term Mutual Funds are a category of debt mutual funds that invest in a diversified portfolio of fixed-income securities such as government bonds, corporate debt, and money market instruments. These funds typically have a portfolio duration longer than low duration funds but shorter than medium duration funds, usually ranging from one to three years. They aim to offer investors potentially higher returns than shorter-duration funds while still managing interest rate risks within a moderate range, making them suitable for investors with a slightly longer investment horizon seeking a balance between risk and returns.

Medium Term Debt Mutual Funds

Medium Duration Mutual Funds belong to the category of debt mutual funds that invest in a mix of fixed-income securities like government bonds, corporate debt, and money market instruments. These funds maintain a portfolio duration longer than short duration funds but shorter than long duration funds, typically ranging from three to four years.

Long Term Debt Mutual Funds

Long Term Mutual Funds refer to investment vehicles that primarily invest in a diversified portfolio of assets such as stocks, bonds, and other securities with a longer investment horizon, typically over five years or more. These funds aim to generate higher returns over an extended period by taking advantage of long-term market trends and potential growth opportunities. They are suitable for investors with a longer time frame, willing to endure market fluctuations, aiming for capital appreciation, and willing to bear higher risk for potentially higher returns.

Gilt Funds

Gilt Mutual Funds are a type of debt mutual fund that primarily invests in government securities issued by the central and state governments. These funds focus on investing in securities with varying maturities and are considered relatively low-risk because they are backed by the government. Gilt funds aim to offer stable returns linked to interest rate movements, making them suitable for conservative investors seeking a low-risk investment option within the fixed-income space.

Dynamic bond funds

The funds have no restrictions with respect to security types or maturity profiles that they invest in. Dynamic or flexible debt funds do not focus on long or short-term segment of the yield curve but move across the yield curve depending on where they see the opportunity for exploiting changes in yields and the duration of these portfolios are not fixed but are dynamically managed. This is suitable for investors comfortable with moderate risk with investment horizons of 3 to 5 years. This timeframe allows the funds to navigate interest rate fluctuations and market cycles to achieve their potential returns.

Floating Rate Debt Mutual Funds

Floating Rate Debt Mutual Funds are a type of debt fund that invests in fixed-income securities with variable interest rates, usually tied to a benchmark like the Treasury bill rate or a reference rate. These funds primarily invest in instruments whose interest rates reset periodically, helping mitigate interest rate risk as their returns adjust with changes in interest rates. Floating rate funds aim to offer investors a potential hedge against rising interest rates while maintaining a degree of stability in their returns compared to fixed-rate instruments.

Fixed maturity plans (FMPs)

These are closed-end funds that invest in debt securities with maturities that match the term of the scheme. The debt securities are redeemed on maturity and paid to investors. FMPs are issued for various maturity periods ranging from 3 months to 5 years. This fund is ideal for individuals seeking stability and certainty in their investments and protection from the interest rate fluctuations.

Debt Mutual Funds Taxation

Debt Mutual Funds Taxation before 1st April 2023

Tax TypeTax Rate
Long Term Capital Gain (> 36 months – with Indexation)20%
Short Term Capital Gain (36 months or less)Slab Rate
Capital Gain Taxes on Debt Mutual Funds before 1st April 2023

Debt Mutual Funds Taxation after 1st April 2023

The recent budget in India has brought about significant changes in the taxation of debt mutual funds. No indexation benefit for LTCG, this means that there is no longer any indexation benefit to offset the impact of inflation on the gains. Both short term and Long-term capital gains (LTCG) from debt mutual funds are now taxed at the applicable income tax slab rates irrespective of their holding period. Read more about the change in debt mutual funds taxation here.

Even after the change in taxation of debt mutual funds, debt mutual funds are still a more appealing investment option than bank fixed deposits or recurring deposits due to the tax deferment. The below table illustrates the comparison between debt mutual funds taxation and bank fixed deposit taxation.

The below table depicts the interest and tax payable on bank deposits;

What are Debt Mutual Funds | Types of Debt Mutual Funds | Debt Mutual Funds Taxation |

The maturity value at the end of the 10th year after taxes in case of bank deposits will be ₹ 8,06,724 i.e., (₹7,69,041+₹53,833-₹16,150). Let us calculate the Compounded annual growth rate (CAGR) = (maturity value/initial investment)^(1/number of years)-1=(₹8,06,724/₹5,00,000)^(1/10)-1=4.90%. The 10-year CAGR from the bank deposits is around 4.90%

The below table depicts the returns and debt mutual fund taxation;

What are Debt Mutual Funds | Types of Debt Mutual Funds | Debt Mutual Funds Taxation |

The future value at the end of the 10th year after taxes in the case of debt mutual funds will be ₹ 8,38,503 i.e., (₹9,19,230+₹64,346-₹1,45,073). Let us calculate the Compounded annual growth rate (CAGR) = (maturity value/initial investment)^(1/number of years)-1=(₹8,38,503/₹5,00,000)^(1/10)-1=5.31%. The 10-year CAGR from the debt mutual fund is around 5.31%

Even though the debt mutual fund gains are also taxed at slab rates but deferring of the tax liability boosts your overall returns. If the funds remain untouched in the debt mutual funds for a several years gives a compounding benefit to your investments.

After knowing the advantages and various types of debt mutual funds available in the market, it’s time to add them to your portfolio. Remember, asset allocation is the key to creating a diversified investment portfolio that suits your individual risk tolerance and goals. By spreading your investments across different asset classes like equity and fixed income investments, you can minimize your overall portfolio risk and maximize potential returns.

This long-term strategy helps you weather market fluctuations and achieve your financial objectives, whether it’s saving for retirement or buying a new home. Remember, there’s no one-size-fits-all approach to asset allocation, so it’s crucial to consider your age, risk appetite, and investment horizon when determining the right mix for your portfolio.

However, it is important to do your research and choose the right investments for your individual needs. If you need help choosing the right asset allocation for you, consider working with a financial advisor. Book a free introductory call today to you assess your needs, goals and develop an investment plan that is suitable for you.

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