All you need to know about investing in debt mutual funds

A sharp rise in bond yields, liquidity, indexation benefits and ability to earn more than traditional deposits are driving investors to debt funds.

What is a debt mutual fund scheme?
A debt fund mutual fund scheme is one that invests in fixed income yielding instruments. Depending on the type of debt scheme, the instruments could be T bills, bank CDs, corporate bonds, government securities or a combination of these instruments. Some of the debt fund categories available to investors are overnight, liquid, ultra short term, short term, medium duration, target maturity funds, credit risk, dynamic bond and government securities fund.


What is the advantage of a debt scheme over a traditional fixed income instruments?
Debt funds have a portfolio of securities and hence help you diversify when compared to a single instrument like a fixed deposit, corporate bond or a non-convertible debenture. A portfolio of a debt scheme helps reduce risk as it has a number of papers. A debt mutual fund is liquid as investors can buy or sell it with the fund house on any working day. If there is a need to withdraw money, a debt mutual fund can be broken into units of `1 and investors can withdraw only the amount required. As compared to this, in a small saving product or a fixed deposit, you would need to break the entire deposit.

What are the tax benefits for an investor in a debt fund?
Tax benefits are one big reason for investors to prefer debt funds. Firstly, there is no tax deduction at source (TDS) in debt mutual funds and if held for three years and above, one can avail indexation benefit and minimise their tax outflow. Fixed deposits do not offer indexation benefits.

What are the risks investors need to keep in mind while investing in a debt fund?
Investors need to know about interest rate risk and credit risk. In a rising rate scenario, bond prices fall and vice versa, which could give mark-to-market losses in the short term. A credit risk is the risk of default on a debt security that may arise from a borrower failing to make required payments. If the scheme holds lower-rated securities and the company does not repay principal or interest on the due date, the fund’s NAV could drop, leading to a loss to investors