While most Indians prefer traditional assured returns products, the declining trend in interest rates has led to investors exploring other fixed income options like debt mutual funds in search of relatively better returns. In order to help investors understand debt funds better, here are 5 key aspects that they ought to know –

1. Helps reduce Portfolio Risk – We are very happy when equity funds deliver 30% returns in a year but when the same funds also deliver negative 30% in a year, our hearts almost stop beating. But that’s how equity markets work. On the other hand, Debt funds can play a strategic role in your portfolio and in overall financial planning. While the stability of returns and relatively low volatility makes them suitable for short-term goals, they also work closely with equity funds to meet long term goals by cushioning the downside portfolio risk.
2. Taxable only on redemption – Unlike bank deposits which are taxed for accrued interest every year at slab rates till maturity (irrespective of whether you have received any cash flows or not), debt mutual funds are taxed only on redemption, that too to the extent of withdrawal only. For example, if you had a 5-year deposit and accrued Rs.1 lakh^* per year as interest, you would pay @Rs.30,000^ per year as tax for 5 years (if you fall in the 30% tax bracket). Remember, you pay tax every year on interest that you would actually receive only after 5 years. However, if you had invested the same money in mutual funds, you would not pay tax every year but pay it only as and when you redeem. So think about the opportunity cost!
3. Offer Indexation benefits – Indexation may sound jargonish but simply put, it allows you to pay tax only on the gains you make over and above the inflation rate. For example, if the returns are 8% and inflation is 5%, you pay tax only on 8% minus 5% which is 3% returns while the rest is exempt. This benefit is available only if you hold debt fund units for 3 years or more and the tax rate is fixed at 20%^. Please note that you cannot claim indexation benefits on bank deposits and you pay tax on the entire 8%* that too at income tax slab rates which could even be more than 20% for those in the highest tax bracket. The table below tries to illustrate this benefit wherein you will notice that the tax payable by a debt fund is less than the tax payable under a traditional deposit. 

4. Tax Efficient Regular Income via SWP – The above Indexation benefits help you to also avail tax efficient regular cash flows from debt funds by using the Systematic Withdrawals Plan or SWP facility offered by mutual funds. Traditional deposits even if offering the same returns may lose out to debt funds on a post-tax basis.
5. No penalty on premature withdrawal – Many debt funds especially overnight funds carry no early withdrawal penalties also known as exit loads unlike traditional deposits. If you wish to seek indexation benefits and redeem only after 3 years, then a majority of debt funds would be in the load free period.

What is the flip side? Debt funds do not provide any assured returns like bank deposits as NAVs can move both ways. This is because interest rates and bond prices move in opposite directions. Bond prices fall when interest rates rise and vice versa. This is also known as interest rate risk. However, debt funds are far less volatile than equity funds. Even within debt funds, short term debt funds are less volatile than long term debt funds. Hence, investors looking at steady returns or regular income may prefer to look at short term debt funds. For those who worry about credit quality of debt funds, they could choose from categories offering only high credit quality portfolios like say banking and PSU debt funds. So let’s look at debt funds from this new perspective going forward. Signing off ‘Till Debt Do us Part”.

* Assuming 8% interest rate p.a. on principal of Rs 12.50 lakhs. The illustration is only for the purpose of explaining the difference in tax computation between debt funds and banks FD. Unlike banks FD, debt funds do not provide assured returns.

^ Excluding surcharge and cess

Information contained in this article is not a complete representation of every material fact and is for informational purposes only. The recipient is advised to consult its advisor/ tax consultant prior to arriving at any investment decision.