What Is a Debt Fund: Meaning, How It Works, Types and Taxation

Debt funds are investment options wherein you invest in securities with fixed income. Inclusions in debt funds are corporate bonds, treasury bills, government securities, commercial papers and others.

These are non-market-linked investment options involving low risk. You can invest in these funds if you are a conservative investor or if you want to diversify your portfolio as a seasoned investor.

Key Highlights

• Debt funds are a type of mutual funds aiming to preserve capital and generate steady income in the form of government securities, bonds, etc.
• Debt funds can mature overnight or after 7 to 10 years.
• Funds investing in high-rated companies can ensure a lower risk of default.
• A good credit rating for debt funds is AA or above.
• You can earn a fixed income from debt fund investments.
• Ensure you check the credit rating before investing in debt funds. 

How Does a Debt Fund Work?

Debt securities are rated by rating agencies like CRISIL, CARE, ICRA and others. The credit ratings help debt fund managers understand the potential for default or the stability of the fund. 

Choosing debt securities with a higher rating, such as AA or above, helps fund managers reduce the risk of default. This further helps investors earn potential returns from their debt portfolio.

Types of Debt Funds

You can classify debt funds based on their maturity tenure, duration and credit quality. Based on maturity, you can categorise debt funds in the following way:

• Overnight Funds: overnight maturity
• Liquid Funds: Matures within 91 days
• Money Market Funds: 12 months
• Gilt Funds: 10 years

You can classify debt funds based on duration in the following way:

• Ultra Short Term Fund: 3 to 6 months
• Low Duration Fund: 6 to 12 months
• Short Duration Fund: 1 to 3 years
• Medium Duration Fund: 3 to 4 years
• Medium to Long Duration Fund: 4 to 7 years
• Long Duration Fund: over 7 years
• Dynamic Bond Fund: Variable duration

You can categorise debt funds based on the credit quality as follows:

• Banking and PSU Funds: At least 80% investment in public sector undertakings, banks, municipal bonds and public financial institutions.
• Corporate Bond Funds: Over 80% investment in AA+ or higher-rated instruments
• Government Securities and Gilt Funds: at least 80% in government securities
• Credit Risk Funds: at least 65% in low credit-rated or below AA instruments

Taxation on Debt Funds

If you purchased a debt mutual fund on 31st March 2023 and sold it on or after 23rd July 2024, with a holding period of less than 2 years, then short-term capital gains tax applies as per your income tax slab rate.

In case you held it for more than 2 years, a 12.5% long-term capital gains tax applies without indexation. However, if you invested in a debt fund on or after 1st April 2023, the applicable tax rate is as per your income tax slab, irrespective of the holding period.

Reasons to Invest in a Debt Fund

One of the main reasons to invest in debt funds is that you can earn a fixed and regular income to meet your expenses. Here are the other benefits of investing in debt funds:

• You can diversify your high-risk equity portfolio with debt instruments to ensure balanced risk.
• Investing in debt instruments helps you avoid market-linked investments while you earn stable returns.
•  You can access debt instruments seamlessly as an institutional investor.
• Investing in debt instruments helps you plan your short to medium-term financial goals with easy liquidity options. 

Things to Consider Before Investing in Debt Funds

One of the key things that you should consider before investing in debt funds is the risk or credit rating. A low credit rating indicates a high risk of default. As a result, you can minimise risks by choosing funds with high credit ratings. Here are the other factors to consider:

• You need to check the potential returns of funds before you choose a fund with good returns or past performance.
• Ensure you check the fees and charges of debt funds, such as the expense ratio, which has an upper limit of 2.25%. Holding your investment for a long term can help you recover the expense ratio.
• You need to check the investment tenure of the fund to ensure it aligns with your financial goals.
• Choosing a debt fund can help you earn a regular income, wherein you need to check the frequency of receiving income.

Final Words

Now that you know what is a debt fund, ensure you diversify your portfolio with debt and equity components. This will help you minimise risks in your portfolio while you earn stable returns.