Debt funds invest in all kinds of debt which can also be considered as lending money to the entity issuing the fund, such as treasury-bills, government securities, commercial paper, certificates of deposits, money market instruments, securitised debt, and corporate bonds. These funds have a fixed maturity date and interest rate that the buyers could earn till the maturity of the security. Debt funds invest in a variety of securities, based on their credit ratings. A security’s credit rating signifies the risk of default in disbursing the returns that the debt instrument issuer promised.
Short-term capital gains (if the units are sold before 36 months) in debt mutual funds are taxed as per applicable tax rate of the investor. Therefore, if your tax rate is 30% then short-term capital gains tax on debt fund is 30% + 4% cess. Long-term capital gains (if the units are sold after 36 months) in debt fund are taxed at 20% with indexation. Also, Dividends received by investors are added to their overall income and taxed at the income tax slab rate they fall under.
Debt funds are considered low-risk investments because you are essentially lending money. However, there are some risks to keep in mind. They are:
1. The interest rate risk- Bond value is connected to the interest rate. So when interest rates rise, bond prices fall and vice versa
2. Inflation risk- Bonds provide fixed returns at regular intervals. But if the rate of inflation grows faster than the fixed amount of income, the investor’s money is devaluing.
3. Credit risk- There is always the risk with any lending, that the borrower defaults. In debt funds this is rare, but possible.
Overnight funds and liquid funds are the safest because they are short-term which reduces the interest rate risk and credit risk that these funds can take.
Overnight funds mature in 1-day. Liquid funds can only invest in debt and money market securities that mature in or up to 91 days.
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