Debt mutual funds have been in the news this past week for the change in their taxation. In today’s article we will understand all about debt mutual funds. But first, let us understand why debt mutual funds have been in news,
The government recently removed the benefit of 20% tax with indexation benefit that these categories of mutual funds presently enjoy.
Simply put, debt mutual funds will now be taxed on a par with fixed deposits. This is as per an amendment to the Finance Bill of 2023, which was tabled by Finance Minister Nirmala Sitharaman and passed in the Lok Sabha on Friday.
Effectively, gains on redemption of mutual funds where not more than 35% is invested in equity shares of domestic companies will be taxed as short-term capital gains if they are bought on or after April 1, 2023.
That is, capital gains from debt funds, international funds and gold funds, irrespective of their holding period, will be taxed at an individual’s relevant tax slab. The amendment also covers funds of funds, which invest in units of other mutual funds.
So, why is this move significant? This is because removing the benefit will end the tax advantage debt funds enjoyed over fixed deposits. Interest income from fixed deposits is taxed at an individual’s income tax slab rate. With the indexation benefit gone, debt funds will come on a par with fixed deposits on the taxation front. In fact, FDs have the added advantage of certainty of returns since the interest rate is fixed when a depositor opens an FD while returns on debt funds are market-linked.
Having said that, existing investments in debt funds, international funds and gold funds, and even new investments made in them until March 31, 2023, may not be impacted, and will continue to enjoy the same benefits as before. So, what should you do? Well, you may have to go back to the drawing board and thing through your asset allocation. And make decisions regarding investments or redemptions in debt funds, FDs or even equities only after a thorough analysis of your goals and requirements.
Now let us understand debt fund in detail,
What are debt funds?
A debt fund is a type of mutual fund that invests in capital-appreciating fixed-income securities such as corporate and government bonds, corporate debt securities, money market instruments, etc. Bond funds and income funds are other names for debt funds.
Benefits of Debt Mutual Fund
Debt Funds can be taken into consideration for investments with horizons of one day to three years. They provide superior post-tax returns to FDs if you invest for at least three years. The liquid debt fund option is a fantastic option to keep your emergency funds. Without taking on too much risk, you can earn higher returns than those from savings accounts.
How does a Debt Fund operate?
Debt funds buy debt instruments, such as corporate and government bonds, that are listed or unlisted at a specific price and then sell them at a profit. The underlying debt instruments in which debt funds invest also pay periodic interest. Debt funds that receive regular interest payments from fixed income securities over the course of the fund’s life are comparable to interest-bearing bank fixed deposits in terms of return.
Daily contributions of this interest income are made to a debt mutual fund. As a result, the NAV of a debt scheme also depends on the interest rates of its underlying assets and any changes in the holdings’ credit ratings.
Why should you invest in a debt fund
Liquidity: Debt funds are perceived as liquid because they can be withdrawn at any time during business hours. A few liquid funds also allow for instant redemption, allowing investors to instantly withdraw up to 50,000 per day, per the scheme.
Tax Efficiency: Debt funds are only subject to taxation upon redemption, and the tax is only applied to the proceeds of the redemption. When investments are held for longer than three years, LTCG (Long Term Capital Gains) of 20% and the benefit of indexation make debt funds more tax-efficient and can help produce higher post-tax returns.
Stability: Debt funds can stabilize an investor’s portfolio because they are generally less volatile than equity funds. This can reduce overall risk and diversify an investor’s portfolio. They are also thought to be a reliable source of long-term, relatively stable income.
Possibility of higher returns: Debt fund investments may offer higher returns than conventional investment options. By selecting the appropriate fund that matches this risk tolerance and investment horizon, an investor can also benefit from shifting interest rates and potentially generate income.
Types of Debt Mutual Funds
Based on the investor’s maturity period, risk tolerance, and investment goals, investors can select from a variety of types of debt mutual funds.
Liquid Fund: Investments made by Liquid Fund are limited to debt and money market securities with residual maturities of up to 91 days. The underlying instruments are reasonably liquid and may provide reasonable returns compared to more conventional routes.
Overnight Fund: This fund makes investments in securities with a one-day maturity. Due to their short maturity periods, Overnight Funds have low credit and interest rate risk and are therefore seen as being reasonably stable.
Money Market Fund: A money market fund invests in securities with a maximum one-year maturity. This fund is a good option for temporarily storing surplus funds. Due to its relatively high liquidity and potential for higher returns, it can also be used as an emergency fund.
Corporate Bond Fund: The corporate bond fund mainly invests in corporate bonds with ratings of AA+ or higher. Investors looking to invest in papers with comparatively lower credit risk and a moderate appetite for risk should consider this option.
Banking & PSU Fund: It invests at least 80% of its assets in debt and money market securities of banks, PSUs (public sector undertakings), public financial institutions, and municipal bodies.
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