A company can raise funds by borrowing from their investors in return of a fixed and periodic interest to the lender along with principal amount repayment. Simply raising debt or loan from the investors.

What is Debt Mutual Fund?

A debt mutual fund is a  type of mutual fund scheme which invests in fixed income instruments with less risk and less volatile like Government and Corporate Bonds, treasury bills, commercial paper. Investing in debt mutual funds provide stable returns along with capital appreciation. Debt mutual funds are also popularly known as Bond Funds or Fixed Income Bonds 

Types of Debt Mutual Fund

In the market, there are many types of debt funds depending on interest rates and maturity period. Below are the different types of debt mutual fund

1. Dynamic Mutual Fund

Dynamic Mutual Funds are dynamic as the maturity period and interest rate is not fixed. The portfolio fund manager changes the composition of these funds as per the fluctuating interest rate regime. The average maturity period differs as these funds are invested taking interest rate calls and investments in longer and shorter duration bonds. This is done to get the benefit of different interest rate as well as the maturity period leading to balanced capital appreciation

2. Income Funds

Income Funds, unlike Dynamic Mutual Funds, invest in debt securities with extended maturities taking a call on interest rates, this makes it more stable than Dynamic Mutual Funds. The average maturity period is around 5 years to 6 years

3. Short Term and Ultra Short- Term Mutual Fund

These are mutual funds which invest in debt securities for a maturity period ranging from 1 year to 3 years. These mutual funds are ideal for those investors who carry a conservative risk approach as these funds are not affected by interest rate movements.

4. Liquid Funds

Liquid funds are a type of debt funds that invest in debt instruments carrying a maturity period of not more than 91 days, which makes the funds almost risk free. Due to the shortest duration of funds, the risk of negative returns is rarely noticed. These funds are a better alternative to savings bank accounts, higher returns, and shorter duration. Mutual fund companies also offer instant redemption on liquid fund investments through unique debt cards

5. Credit Opportunities Fund

Credit Opportunities Funds are relatively higher riskier than other debt mutual funds. These funds earn higher returns by taking a call on credit risks or by holding lower-rated bonds that come with higher interest rates, ignoring the maturity of instruments.

6. Fixed Maturity Plans

Fixed Maturity Plans are debt mutual funds that invest in securities having a fixed horizon for which the invested amount is locked-in bearing a predetermined interest rate with tax-efficient returns. These fixed-income securities are corporate bonds and/ or government securities, where investment is allowed only during the initial offer period

How does Debt Mutual Fund work?

Based on the credit rating of the securities, the debt fund manager invests in the securities. A higher credit rating means lesser volatility of the underlying securities. Higher credit ratings ensure timely returns as well as principal repayment.

The maturity of the fund also depends on the strategy adopted by the fund manager and the overall interest rate regime in the country

Taxation of Debt Mutual Fund

Debt Mutual Funds are taxed under Capital Gains as per the holding period of the investment.

Short Term Capital Gain- STCG occurs when the investment is held for a period less than 3 years from the date of investment in the fund

Income from investments in debt fund for a period less than 3 years will be taxed under STCG. Gain from the investment will be added to your overall income and rate of tax will be as per the income tax slab rate

Long Term Capital Gain- LTCG occurs when the investment is held for a period greater than 3 years from the date of investment in the fund

Income from investments in debt fund for a period greater than 3 years will be taxed under LTCG. LTCG on Debt Mutual Funds are taxed at a rate of 20% after indexation.

Indexation is a method of calculating the effect of inflation from the date of purchase to the date of sale of the investments. After indexation, the purchase price is inflated to give effect of inflation and bring in the equilibrium of the inflation affected the sale price of the current year. This way the quantum of the capital gain will be lowered.

Best Debt Funds In India

Now that you know what debt funds are and how they can serve your investment objectives, here are a few of the best debt mutual funds in India, based on past performance:

1. ICICI Prudential Liquid Fund – Direct Fund-Growth
2. Axis Liquid Fund- Direct Plan-Growth
3. DSP Liquidity Fund – Direct Plan-Growth
4. Nippon India Liquid Fund - Direct Plan