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Understanding Debt Funds: Risks, Benefits & Its Tax Implication

Updated: Sep 20, 2023



What is Debt Mutual Fund
What is Debt Mutual Fund



Debt mutual funds have been gaining popularity in India as a viable investment option that offers a steady stream of income with relatively low risk. These funds invest in fixed-income securities such as government bonds, corporate bonds, and other debt instruments. In this blog, we will dive deeper into debt mutual funds in India, discussing their types, benefits, and risks.


These funds aim to provide investors with a steady stream of income through regular interest payments while minimizing the risk associated with equity investments.


Debt mutual funds offer several advantages over other investment options, such as liquidity, diversification, and low-risk exposure. These funds are highly liquid, allowing investors to redeem their investments at any time, making them an ideal choice for short-term investments. Additionally, debt mutual funds invest in a diversified portfolio of fixed-income securities, providing investors with exposure to a variety of issuers and maturities.


Moreover, debt mutual funds are relatively low-risk compared to equity investments, making them a suitable option for risk-averse investors. These funds are managed by experienced fund managers who aim to maximize returns while minimizing risk through careful selection of fixed-income securities.


Types of Debt Mutual Funds :


Liquid Funds: Liquid funds invest in short-term money market instruments such as treasury bills, commercial papers, and certificates of deposits. These funds have a maturity period of up to 91 days and are considered the safest debt mutual fund type. Liquid funds provide a higher yield than savings accounts and are an excellent option for investors looking for a low-risk, short-term investment option.


Ultra Short Duration Funds: Ultra short duration funds invest in fixed-income securities with a maturity period of up to one year. These funds offer higher returns than liquid funds but have slightly higher risk. Investors looking for a slightly higher return than liquid funds but are still risk-averse, can consider ultra-short duration funds.

Short Duration Funds: Short duration funds invest in fixed-income securities with a maturity period of up to three years. These funds offer a moderate risk-return profile and are suitable for investors with a medium-term investment horizon. Investors looking for higher returns than ultra-short duration funds can consider short duration funds.


Medium Duration Funds: Medium duration funds invest in fixed-income securities with a maturity period of up to four years. These funds offer higher returns than short duration funds but have a higher risk as well. Investors with a slightly longer investment horizon and a higher risk appetite can consider medium duration funds.

Long Duration Funds: Long duration funds invest in fixed-income securities with a maturity period of more than seven years. These funds offer high returns but are associated with higher interest rate risk. Investors with a long-term investment horizon and a high-risk appetite can consider long duration funds.

Corporate Bond Funds: Corporate bond funds invest in fixed-income securities issued by companies. These funds offer higher returns than government bonds but are associated with higher credit risk. Investors looking for higher returns than government bonds can consider corporate bond funds.


Benefits of Debt Mutual Funds :

Regular Income: Debt mutual funds offer regular income in the form of interest payments. These funds are a popular choice among retirees and other income-seeking investors.

Liquidity: Debt mutual funds are highly liquid and can be redeemed at any time, making them a good choice for short-term investments.

Diversification: Debt mutual funds invest in a variety of fixed-income securities, providing investors with diversification benefits.

Low Risk: Debt mutual funds invest in fixed-income securities that are relatively low risk compared to equity funds. This makes them suitable for investors with a low-risk appetite.

Professional Management: Debt mutual funds are managed by experienced fund managers who make investment decisions based on the fund's investment objective. Investors benefit from the fund manager's expertise in selecting the right mix of fixed-income securities.

Risks of Debt Mutual Funds :

Interest Rate Risk: Debt mutual funds are exposed to interest rate risk. If interest rates rise, the value of the fixed-income securities held by the fund may fall, leading to a decline in the net asset value (NAV) of the fund. Conversely, if interest rates fall, the NAV of the fund may rise.

Credit Risk: Debt mutual funds that invest in lower-rated fixed-income securities are exposed to credit risk. If the issuer of the security defaults on its payments, the fund may suffer losses.

Inflation Risk: Debt mutual funds may not provide adequate returns to beat

Taxation of Debt Mutual Funds before 1 April 2023 :

Earlier, the taxation of debt mutual funds was governed by the holding period rule:

Short-Term Capital Gains: If the debt mutual fund unit is sold within 36 months (three years) of purchase, the gains are termed short-term capital gains (STCG). These short-term capital gains were added to your other income and taxed at slab rates.

Long-Term Capital Gain: However, if they were sold after 36 months, then the gains were termed as long-term capital gains (LTCG). These long-term capital gains were taxed at 20% with an indexation benefit. Indexation benefit means the gains made by investors were adjusted for inflation. This is illustrated in the table below.

Taxation of Debt Mutual Funds after 1 April 2023 :

The Budget 2023 has introduced certain amendments that will result in a Specified Mutual Fund losing its indexation benefit for the computation of long-term capital gains (LTCG). As a result, debt mutual funds will now be subject to taxation at the applicable slab rates. Additionally, LTCG on gold mutual funds, hybrid mutual funds, international equity mutual funds, and funds of funds will no longer be eligible for indexation benefits. These changes may have a negative impact on mutual fund houses as investors may opt to invest directly in debt securities instead of debt mutual funds to avoid AUM fees/charges. Moreover, the tax burden on profits may increase, affecting the appeal of these mutual funds as an investment option.




Comparison of Debt Fund Return-Old Taxation vs New Taxation :



Should you still Invest in Debt Fund instead of Fixed Deposit?

Although there have been recent developments indicating that debt funds have become comparable to fixed deposits, there remain several persuasive arguments in favour of considering debt funds as a valuable investment option for saving on taxes.



  1. For instance, unlike fixed deposits, debt mutual funds are only subject to taxation when the investments are sold. Therefore, it can help you in deferring taxes.

  2. The flexibility of withdrawing funds without any penalty is a characteristic feature of Flexi FDs. However, if you choose to invest in regular FDs, you might be liable to pay a penalty for early withdrawal. On the other hand, debt funds do not impose exit loads after a specific period. This translates to enhanced liquidity and potentially lower costs in comparison to Bank FDs.

  3. Generally, debt funds generate greater returns than fixed deposits.

  4. Debt mutual fund profits are classified as capital gains, whereas fixed deposits fall under the category of 'income from other sources.' Consequently, if there are losses incurred in debt mutual funds, they can be carried forward and set off against any gains.

At last Debt Mutual Fund were a good option for Investment earlier when investors had the option to avail the Indexation & LTCG benefit however with the new tax laws its not the best option as an Investor can invest in Balance Advantage Fund where with more Equity exposure will avail a tax exemption up to ₹1Lac on Capital Gain & rest will be taxed at 15%

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