Debt funds

What are Best Debt Mutual Funds?

A debt fund is a Mutual Fund scheme that invests in fixed income instruments
, such as Corporate and Government Bonds, treasury bills, corporate debt securities, and money market instruments etc. that offer the capital appreciation. Debt funds are also referred to as Fixed Income Funds or Bond Funds.

A debt fund manager invests predominantly in the underlying assets based on their respective credit ratings. A higher credit rating indicates that debt security has a higher chance of paying interest regularly along with the repayment of the principal upon expiry of the investment tenure. Apart from that, the fund manager aligns his investment strategy as per the interest rate movements.

Who Should Invest in Best Debt Mutual Funds?

Best Debt mutual funds are suitable for risk-averse or for those who are not ready to have equity exposure. Debt funds grow investors’ wealth with little to no risk. Additionally, these funds strive to provide regular income. Investors usually stay invested in debt funds for a short to medium-term horizon.

You need to choose an Best debt mutual fund as per your investment horizon. Liquid funds may be suitable for a short-term investor who generally parks his or her surplus funds in a savings bank account. Liquid funds provide returns in the range of 7-9%. They also offer flexibility in terms of withdrawals at any time, just like a regular savings bank account.

If you need to ride the interest rate volatility, then dynamic bond funds may be an ideal option. These funds are suitable for a medium-term investment horizon to earn higher returns than a 5-year bank FD.

Taxation of Debt Fund

The dividends provided by mutual funds were previously made tax-free in the hands of investors until January 2020. The fund house was supposed to pay dividend distribution tax (DDT) at applicable rates before making the dividend payout to the investors. This was changed in the Union Budget 2020. The dividends are now taxed classically. Meaning, the dividends are added to your overall income and taxed as per the income tax slab you fall under.

The rate of taxation of capital gains depends on the holding period of your investment. If the debt mutual fund units are sold within a holding period of three years, you make short-term capital gains. These gains are added to your overall income and taxed as per the income tax slab you fall under. You realise long-term capital gains on selling your debt fund units after a holding period of three years. These gains are taxed at a rate of 20% after indexation.

Risks Associated With Debt Funds

Debts funds possess the following risks:

  1. Credit Risk This is the possibility of the issuer of the debt security not standing by his obligation of returning the principal at the time of maturity, and regular interest payout.
  2. Interest Rate Risk This is the possibility of the movements in the interest rate offered by the underlying securities of the fund plan.
  3. Liquidity Risk This is the possibility of the mutual fund house not having sufficient levels of liquidity to cater to the redemption requests.

Things an Investor Should Consider While Investing in Debt Funds

The following are some of the factors that must be considered before investing in debt funds.

  1. Fund Objectives Debt funds aim at optimising returns by diversifying the portfolio by investing across a variety of securities. You can expect these funds to perform predictably. It is because of this reason that debt funds are suitable for conservative investors.
  2. Fund Category Debt funds are further classified under various categories such as liquid funds, monthly income plans (MIPs), fixed maturity plans (FMPs), dynamic bond funds, income funds, credit opportunities funds, GILT funds, short-term funds, and ultra short-term funds. These funds come with their own set of objectives to achieve and advantages. You have to assess your requirements and invest in a suitable debt fund.
  3. Risks Debt funds are subject to interest rate risk, credit risk, and liquidity risk. The fund value may fluctuate due to the movement in the overall interest rates. You have to assume these risks when you invest any debt fund plan.
  4. Cost Debt funds charge an expense ratio to manage your investment. No fund house can charge above the limit set by the Securities and Exchange Board of India (SEBI). The expense ratio varies across mutual fund plans.
  5. Investment Horizon An investment horizon of three months to one year is ideal for liquid funds. If you have a longer horizon of say two to three years, then you can explore short-term bond funds.
  6. Financial Goals Debt funds can be used to achieve a variety of goals such as earning additional income or for liquidity and earning much higher returns than a regular savings bank account. You have to ensure that your requirements are in with the objectives of the debt fund scheme you are choosing.

How to Evaluate Best Debt Mutual Funds?

The following are some of the factors that must be considered before investing in debt funds.

  1. Fund ReturnsIt would help if you looked for consistency in returns over long-term, say three, five, or ten years. Choose funds that have outperformed the benchmark and peer funds consistently across different time frames. However, remember to analyse the fund performance, which matches your investment horizon to get results. Note that the past performance is not indicative of future returns.
  2. Fund HistoryChoose fund houses that have a strong history of consistent performance in the investment domain. Ensure that they have a consistent track record of at least say five to ten years.
  3. Expense RatioIt shows how much of your investment goes towards managing the fund. A lower expense ratio translates into a higher take-home return. If there are two funds with a similar asset allocation and returns, then choose the fund which has a lower expense ratio and has the potential to give you superior performance.
  4. Financial RatiosYou can use financial ratios such as standard deviation, Sharpe ratio, alpha, and beta, to analyse a fund. A fund having, higher standard deviation, and beta are riskier than a fund with lower beta and standard deviation. Look for funds with a higher Sharpe ratio, which means it gives higher returns on every additional unit of risk being taken.

Advantages and Disadvantages

The following are some of the most significant advantages of investing:


  • Retain control. When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
  • Tax advantage. The amount you pay in interest is tax deductible, effectively reducing your net obligation.
  • Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.

Disadvantages Debt financing has its limitations and drawbacks

  • Qualification requirements. You need a good enough credit rating to receive financing.
  • Discipline. You’ll need to have the financial discipline to make repayments on time. Exercise restraint and use good financial judgment when you use debt. A business that is overly dependent on debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.
  • Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk. You might also be asked to personally guarantee the loan, potentially putting your own assets at risk.

Deciding Factor

  • How important is it for you to retain full control of the business?
  • How important is it to know precisely what you’ll owe in monthly payments?
  • Are you comfortable with making regular monthly payments?
  • Are you able to qualify for debt financing? How is your credit history? Do you have a good credit rating?
  • Do you have collateral you can use? Are you comfortable with using it?
  1. Not influenced much by market movements The performance of best debt mutual funds are not influenced much by the market movements. Hence, these funds are less volatile as compared to equity funds. The portfolio of debt funds is mostly constituted with fixed-income securities.
  2. Stable portfolio Since the fund invests in fixed-income securities, the returns offered by debt mutual funds are much stabler. Therefore, risk-averse investors should consider investing in these funds.
  3. Best for first-time investors First-time investors may consider investing in debt funds to get started with their investment journey. This gives them the much-needed glimpse of what mutual funds are capable of.
  4. Best option to park surplus funds Since debt funds are highly liquid, you can consider investing your surplus money in these funds and earn much higher returns than a regular savings bank account

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