Many people, when it comes to investing, think primarily about stock market instruments like shares and equity funds. While these can offer higher returns, they also come with significant risk.
A well-diversified portfolio, however, includes a mix of asset classes, and one such asset class is debt. Debt provides a more stable and predictable source of returns, balancing the volatility of equities. And a popular way to invest in debt is through debt mutual funds.
In this post, I will talk about what debt funds are, their types and taxation, so you can understand how they fit into your investment strategy.
What are debt funds?
Debt funds are a type of mutual fund that invest your money in fixed-income securities like government bonds, corporate bonds, and other money market instruments, without directly managing individual instruments.
Think of it as loaning your money to companies or the government, and in return, you earn interest. This makes debt funds less volatile than equity funds, making them a suitable option when your goal is to park money for the short term, maintain liquidity, or earn steady returns with lower risk.
Types of debt funds
There are different types of debt funds, each suited for specific investment goals, risk appetites, and time horizons. Let’s explore some of the most common ones:
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Liquid Funds
These funds invest in short-term investments (up to 91 days), offering high liquidity and low risk. They’re ideal for parking money for short-term, with minimal fluctuations.
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Corporate Bond Funds
These funds invest in corporate bonds, aiming to provide better returns with relatively more risk than government bonds. These funds are suitable for medium-term investors looking for a balance between risk and reward.
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Gilt Funds
These funds invest in government securities, offering low risk and stable returns.
They’re for conservative investors who want to protect their money and earn steady returns over time.
But that’s not all. There are also other options like money market funds, banking and PSU funds, dynamic bond funds, and credit risk funds, each catering to different investment needs and risk profiles.
Now that we’ve covered the types of debt funds, it’s important to understand how they are taxed.
Taxation of debt funds
Taxation of debt funds has undergone a lot of changes over past 3 years. Earlier, they used to be taxed differently for short-term vs long-term, and later on it was all made the same irrespective of the holding period.
So if you hold debt mutual funds, your taxation will depend on when they were purchased and how long they were held.
Let’s take a look at the details in the table below:
1. For debt funds purchased before 1st April 2023
- If sold before 23rd July 2024:
- Short-term gains (held for less than 36 months) will be taxed at your income tax slab.
- Long-term gains (held for more than 36 months) are taxed at 20% with indexation, meaning the purchase price is adjusted for inflation, reducing the taxable gain.
- If sold on or after 23rd July 2024:
- Short-term gains (held for less than 24 months) will be taxed at your income tax slab.
- Long-term gains (held for more than 24 months) are now taxed at a lower tax rate of 12.5%, compared to the previous 20%.
2. For debt funds purchased after 1st April 2023
- In this case, the gains will be taxed at slab rate, irrespective of the holding period or date of sale.
Because of the increased tax rebate, gains from debt funds taxed at slab rate will be completely tax-free up to ₹12 lakh from FY 2025-26 onwards. Read more here.
Here’s a short read on taxation of equity stocks & mutual funds.
Happy investing!