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Debt Mutual Funds: An Analysis

Fixed-income instruments such as corporate bonds, government securities, and several other debts are the direct investments of debt mutual funds.

The AUM of debt mutual funds fell sharply in February. All of the debt fund types combined saw a net outflow of Rs 8,274.29. In January, the outflow totaled Rs 5087 crore. All other debt categories had considerable outflows, except liquid and overnight funds. According to market analysts and fund managers, the uncertainty in the rate cycle and the future trajectory of rates is to blame for the drop.

What are debt mutual funds?

Professional fund managers oversee debt mutual funds. Its mission is to invest the fund’s assets in bonds issued by private and public firms and the government, following the fund’s investment objectives.

Debt mutual funds, unlike equity funds, are directly influenced by interest rate changes. Your debt fund invests in long-term papers when interest rates are falling. This is due to the substantial reinvestment risk associated with short-term securities. They invest in short-term papers as interest rates climb.

How do debt funds work?

Whenever you invest in a debt fund, you essentially lend the borrowers money. This loan can be for a short, ultra-short, or extended period. This loan will also have a set maturity date and an agreed-upon interest rate. The borrower will reimburse you the principal amount plus the final interest payment when the loan matures.

Taxation on Debt Funds

Previously, dividends from mutual funds were tax-free in possession of investors till January 2020. Before paying dividends to investors, the fund house was required to pay dividend distribution tax (DDT) at the applicable rates. The Union Budget 2020 made a change to this. Dividends are now subject to traditional taxation. In other words, dividends are added to your entire income and taxed according to your tax bracket.

The rate of capital gains taxation is determined by the holding period. Short-term capital gains are realised if debt fund units are sold during three years of purchase. These profits are added to your entire income and taxed according to your tax bracket.

After a three-year holding period, you sell your debt fund units and realise long-term capital gains. After indexation, these gains are taxed at a rate of 20%.

How can you analyze various debt mutual fund schemes?

Liquid Funds: Since commercial papers are often unstable, a liquid fund with higher exposure to them is more volatile. As a result, while the fund may produce outstanding returns, it will also have a higher risk. In a liquid fund, the number of NBFCs to which it is exposed, the credit ratings of the securities (although most short-term securities have higher ratings), and the scheme’s corpus all matter.

Short-term debt funds: These funds invest in corporate bonds, government bonds, and bank certificates of deposit, among other securities. Securities in these funds typically have a 1-2 years maturity and are marked to market. Within this category, one must consider the fund’s portfolio makeup. Funds with significant exposure to corporate bonds will be more volatile, but they may have a better chance of providing higher returns.

Ultra short-term debt funds: These funds are similar to liquid funds, but they can invest in assets that have a maturity of more than 91 days. Because a major portion of the securities held by these funds is transacted, their prices have a greater impact on the NAV of Ultra Funds than on the NAV of liquid funds. As a result, these funds have a higher level of volatility. Unlike liquid funds, this strategy is designed for a three-month investment horizon.

Income funds: Long-term income funds often invest in government bonds, certificates of deposit, corporate bonds, and money market products. These securities have a longer average maturity and are subject to interest rate fluctuations. On the other hand, these funds are believed to be less volatile due to their exposure to CDs and Corporate Bonds of various maturities.

Bottom Line

It is crucial to pick a debt strategy that fits your investing horizon and risk appetite. You can choose a liquid fund if you only invest for a few months. If you plan to invest for a year, you can choose an ultra short-term strategy.

You can choose a corporate bond fund or a banking and PSU bond fund if you plan to invest for three years or more. You can invest in gilt funds if you comprehend interest rate risk. When interest rates are declining, these plans may give bigger yields.

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