What is a debt mutual fund, and is it worth investing in it?

A mutual fund is an investment option that gives investors a variety of options to choose from according to their risk appetite and goals. For instance, if you are a risk taker, you may choose to invest in equity mutual funds that exhibit similar characteristics as equities.

At the same time, if you are a conservative investor, debt funds are a viable option. But what are debt funds? Is investing in them worth it? Let us find out.

What is a debt fund?

Mutual funds that invest in debt securities, government bonds, corporate debt securities, money market instruments, and other fixed-income instruments are together referred to as debt funds. Some other names for debt funds are income funds and bond funds. Mutual funds that invest in debt often provide a stable return. It lessens the risk since the rate of return is far less likely to change. Various types of bonds and bills issued by the government and private companies serve as an illustration. People who aren’t informed mistakenly believe that risk-free investments like CDs and savings accounts are the best way to put money down for the future. Whereas, debt funds provide a return rate that is comparable to that of bank fixed deposits, with the added benefit of a chance for growth. Still, many investors remain clueless about the potential for large yields while taking on very little risk with debt funds.

Advantages of investing in a debt fund

  • Debt funds, in contrast to classic channels, do not have a lock-in period and may have their holdings redeemed at any time, but are subject to the payment of any necessary exit costs. Because they may be withdrawn on any business day, debt funds are categorized as liquid assets. A select few liquid funds provide investors with the option of quick redemption, which enables them to withdraw up to 50,000 per day, per plan, per investor.
  • It’s possible that debt funds will provide better tax efficiency than more standard investment vehicles. When debt funds are redeemed, it is the only time they are subject to taxation, and tax is only paid on the proceeds of the redemption. This is in contrast to other typical investment vehicles, which take a tax deduction on the interest that is collected each year. The investor is responsible for paying taxes on any dividends received from debt funds, and the amount of those taxes is determined by the investor’s tax bracket.

When assets are held for more than three years, the advantage of indexation may assist give superior after-tax returns, making debt funds a potentially more tax-efficient investment option. This is because the LTCG (long-term capital gain) rate for debt funds is 20%.

  • An investor’s portfolio might benefit from the relative stability provided by debt funds since these funds are more stable than equity funds on average. This may assist in increasing the portfolio’s level of diversification and lowering the overall risk. They are also seen as a reliable source of income over a period, which contributes to their overall attractiveness.
  • Traditional investment vehicles, such as stocks and bonds, may not provide the same level of return potential as debt fund investments. An investor has the opportunity to profit from fluctuating interest rates and increase their income by selecting the appropriate fund that corresponds to their level of risk tolerance and time horizon for making investments.

Conclusion

Debt funds are a viable option, especially for conservative investors. But that doesn’t mean they are risk-free. There are a variety of risks associated with debt funds, including credit risk and interest rate risk. Credit risk is the risk of failure on security that might come from a borrower failing to make the appropriate payments. This risk can occur when a borrower does not pay back the money they borrow. When this occurs, it is often the result of investments made in assets with a poor credit rating. The risk of a decline in bond prices due to an increase in interest rates is referred to as interest rate risk.

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