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Four Benefits Of Investing In Debt Mutual Funds

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Created on
August 19, 2022

Summary

What’s Inside

If mutual funds have been on your radar for a while now, you may find yourself gravitating to the more popular kind of funds, namely equity funds. But their safer counterparts — debt mutual funds — also have a lot to offer investors. Want to know more about the benefits of investing in debt mutual funds? 

Let’s get started and go over four main benefits of investing in debt mutual funds.

Four Benefits of Investing in Debt Mutual Funds

At a glance, the top four benefits of debt mutual funds include safer returns, low investment cost, high liquidity and more tax efficiency. Sounds like something your financial goals can benefit from? Well, in that case, let’s take a closer look at these advantages. 

Stable Returns

One of the most defining benefits of investing in debt mutual funds is that they give you stable and low risk returns. These funds invest in debt instruments like government bonds, corporate bonds, bonds issued by PSUs and banks, and other such debt securities. These instruments all carry a fixed rate of interest on them. So, when you invest in a debt mutual fund, you will have a fair idea of the returns you will earn from your investment. 

On the other hand, funds that are linked to the equity markets do not carry any fixed rate of return on them. True, the potential for earning higher returns exists. But you will not know upfront what the rate of return is. 

So, one of the many benefits of debt mutual funds is that they give you stable and safe returns. If you are a conservative investor who is risk averse, you will no doubt find that debt funds are ideal for your portfolio for this reason. 

Low Investment Cost

Another notable benefit of investing in debt mutual funds is that it comes with low investment costs. You see, every mutual fund needs to be managed efficiently, so the inventors’ funds can be invested in an optimal manner. The typical expenses involved in running a mutual fund include administrative expenses, investment management costs, advertising and marketing costs, transaction fees and so on.

These expenses are expressed as a percentage of the total fund value of the assets in the mutual fund scheme. This ratio is known as the Total Expense Ratio (TER). Let me give you the formula for the TER, for more clarity.

Total Expense Ratio = (Total cost of the mutual fund scheme ÷ Total fund assets) x 100

These costs can be fixed by mutual fund companies. However, in order to protect the interests of investors like you, the Securities and Exchange Board of India (SEBI) has set a limit on the maximum TER that mutual fund houses can charge. 

For debt mutual funds, the maximum TER has been set at 2%. So, your total cost of investment cannot exceed 2% of the assets in the fund. This is quite a low margin, making debt mutual funds very cost-effective. 

High Liquidity 

Many other safe investment options like fixed deposits and the Public Provident Fund (PPF) come with definite lock-in periods. You may be able to withdraw your funds, but at the cost of a penalty. In the case of debt mutual funds, you enjoy more liquidity. There is no specific lock-in period, per se. 

You can easily liquidate your debt fund investments as and when you need them. You can even choose from debt funds of varying maturity periods, so your investment horizon matches the investment tenure. For instance, you can park some of your money in short duration debt funds, to increase the liquidity in your portfolio. The rest of your capital can be invested in long term debt funds. 

Tax Efficiency

Another often overlooked benefit of debt mutual funds is that they are quite tax efficient. The gains you earn when you liquidate your debt fund investments can be of two types —

  • Short Term Capital Gains (STCG) is when you liquidate your investments within 36 months 
  • Long Term Capital Gains (LTCG) is when you held your investments for over 36 months 

STCG Taxation

STCG is taxed at your income tax slab rate itself. So, if you are in a lower income slab, where your tax rate is 1o% or 20%, that is the rate that will be applicable to your debt fund gains too. 

LTCG Taxation

LTCG, on the other hand, is taxed at 20%, but you get the benefit of indexation. Indexation is simply the process of adjusting your purchase price, so it factors in inflation. 

For example, let’s consider the following situation —

  • You purchased your debt fund units for ₹1 lakh in FY 2012-13. 
  • And today, you sell them for ₹3 lakh 
  • The capital gains without inflation come up to ₹2 lakh

These gains can be partly attributed to inflation too. So, since it is not fair to tax you for inflationary gains, the Income Tax Department introduced the concept of indexation. Here, your purchase price is increased by a specific factor known as CII, which is fixed by the IT department for each financial year. Check out the formula used to arrive at the indexed purchase price.

Indexed Purchase Price = (CII of year of sale ÷ CII of year of purchase) x (Purchase cost)

So, in the example we’re discussing, the CII for 2012-13 is 200, and the CII for 2022-23 is 331. Using these numbers in the formula, the indexed purchase price you get is Rs. 1,65,500. And your LTCG after indexation comes out to be just Rs. 1,34, 500 (Rs. 3,00,000 minus Rs. Rs. 1,65,500).

See how indexation lowers your capital gains and thereby reduces your tax liability? This is how you get more tax efficiency with debt mutual funds. 

Summing Up

By including debt mutual funds in your investment portfolio, you can enjoy the benefits outlined above. So, whether you want safer returns or more tax efficient investments, debt funds may help you check all the right boxes. Before you invest in a debt fund, however, make sure you take a look at the fees and charges upfront, so you are not caught off guard later. Nobody likes a surprise bill, after all. 

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Frequently Asked Questions

1. Is a debt mutual fund risk free?

Depending on the kind of debt instruments that the fund invests in, a debt mutual fund may carry its own degree of risk. So, each kind of debt fund comes with a different level of risk. Some, like gilt funds, carry almost zero credit risk, while others, like corporate bond funds, may come with a higher risk. 

2. Why should you invest in debt funds?

There are many benefits of investing in debt mutual funds. The returns are more stable, the fees may be lower, and you get the benefit of indexation on your taxes. You can also enjoy greater liquidity with debt mutual funds, depending on the kind of debt fund you invest in.

3. Which type of debt fund is the best?

There is no single fund that can be tagged as the best debt mutual fund. The answer to this varies from one investor to another, based on their needs and financial goals. For instance, if you are planning to invest for a goal that you need to accomplish in the next 2 years, a short duration fund may be better for you. On the other hand, if you want to invest for the long term, a long duration fund may be more suitable. 

4. Which debt fund gives the highest return?

There are many debt mutual funds in India that have given good returns over the past few years. Some of the top performing debt funds include the UTI Bond Fund and Nippon India Strategic Debt Fund.

Disclaimer

Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.
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