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Debt Mutual Funds: A perfect choice for conservative investors

By Nivesh Gyan   8 August

Category: Better Than FDs

A common question in investor’s mind: Interest on money lying in savings account is too low and if I park that money in a fixed deposit, return is not great there too plus there is no flexibility. What should I do?
 
The answer to this question for a conservative investor is “Invest in Debt Mutual Funds”.

What are Debt Mutual Funds?

  • Debt funds represent the category of mutual funds that invest in a mix of debt or fixed income securities.
  • Debt securities are loans taken by either Government or Companies. These securities have fixed maturity date and pay fixed rate of interest.
  • As the Debt Mutual Funds invest in securities with fixed interest, the returns of these funds are more predictable and less volatile.
  • The returns of a debt mutual fund include interest income and capital appreciation / depreciation in the value of the security due to changes in market dynamics. There could be a risk element if the Company, which has issued the debt security, defaults in timely payment of interest or the principal.
  • Debt securities are assigned a ‘credit rating’, which helps assess the ability of the issuer of the securities / bonds to pay back their debt, over a certain period of time.

Why invest in Debt Mutual Funds?

  • Variety: Debt funds offer a wider variety – you can invest in debt funds that invest only in Government Securities or the ones that invest in securities of Companies. Further, there are debt funds with short term profile as well as long term ones.
  • Tax efficient: Debt funds are tax efficient than fixed deposits. If held for over three years, the gains are treated as long-term capital gains and taxed at a lower rate of 20% after indexation. Indexation takes into account the inflation during the holding period and accordingly raises the acquisition price of the asset. Because of this you pay very nominal amount of tax compared to fixed deposits.

Let’s understand this with an example:

Particulars Debt Funds Fixed Deposits
Amount Invested 2,00,000 2,00,000
Rate of Return 7% 7%
Tenure 3 years 3 years
Value at the end of 3 years 2,45,000 2,45,000
Inflation 6% 6%
Sum indexed with the Cost Inflation Index (provided by the Income Tax department) 2,38,000
Amount Taxed 7,000 (2,45,000-2,38,000) 45,000
Tax to be paid 1,400 (20% of 7,000) 13,500 (30% of 45,000)
Total Return after Tax 43,600 31,500

Why should you choose Debt Funds over Fixed Deposits?

Debt Funds Fixed Deposits
Return ~8%-9% 6%-8%
Risk Moderate Low
Liquidity High Low
Investment option Can invest via both SIP and Lumpsum route Can invest only in Lumpsum

Which category of Debt Mutual Funds you should invest in?

Ultra short-term funds if you have short term surplus for a time period of approximately 0 to 9 months.
 
Credit Risk Funds if you are looking for lucrative returns and are aware of the fact that these funds invest at least 65% of their investments in less than AA-rated paper. These funds typically generate 2-3% higher returns compared to risk-free papers as they take higher credit risk by investing in lower-rated papers. Market price of such securities goes up as and when their ratings move up, and they offer a benefit of capital gains.
 
Fixed Maturity Plans (FMPs) are apt for 3 years if you are looking for predictable returns for a particular tenure. Their objective is to provide steady returns over a fixed-maturity period and are suitable for investors who wish to avoid interest rate risk and are willing to invest in safer debt instruments which would earn marginally higher than savings account and bank fixed deposit.

Debt Funds and Taxation

Holding Period Income Treatment Tax Implication
Less than 3 years Short-Term Capital Gain Added to income and taxed as per individual’s tax bracket of 10%, 20% or 30%
More than 3 years Long-Term Capital Gain 20% with indexation benefit on cost and 10% without indexation benefit

 
 
Please contact Nivesh.com to understand in detail about debt funds and identify the fund that meets your time horizon and risk appetite.