There are currently 16 different categories of debt funds available. The regulator has segregated the schemes based on the modified duration of the underlying portfolio, while certain categories like Credit Risk Funds and Corporate Bond Funds are defined as per the credit quality of the underlying portfolio. Mutual funds are expected to generate the best risk-reward based on the scheme’s investment mandate and in ultimate good faith of the investor. However, in the quest to generate a higher alpha, some fund managers tend to take on a higher risk. Naive retail investors often bear the brunt of these investment decisions if the promoter companies are unable to pay up.
Here we discuss in brief about Short term debt funds, its meaning, features and objective to invest. Investment in the capital markets always exposes your capital to the risk of volatility. So, it is not suitable for those investors who depend on their savings for livelihood.
Short Term Debt Funds: Features
Short Term Debt Mutual Funds provide an alternative to traditional Fixed Deposits and Monthly Income schemes.
Short term debt funds can offer higher returns and low volatility.
These are also known as income funds.
These fund invests in Govt. and companies debt instrument and money market instrument of shorter duration of maturity of up to 3 years.
These are highly liquid debt instruments and also help the investors to fight inflation.
How Debt Funds work?
The fund generates its return from interest it receives from bonds and capital appreciation.
The bonds are traded at regular market and bond prices are affected by Interest Rates Risk i.e bond price and interest rate moves in opposite direction, credit risk, and inflation.
For example: If the interest rate falls in the economy, new debt instruments starts getting issued at newer rates less than previous rates. Then investors start to buy the old bonds which have high rates and the price of bond increases.
What's your take on Short term debt funds in India? There are so many investing instruments, one tends to get confused. So, be careful in planning your investments.
Taxation treatment is an important aspect of investment in Debt Funds. This post discusses about Debt Funds Taxation in detail
Debt Funds Taxation
Everyone would like to earn more and more income and want to achieve their financial goals in life. With the increase in income, the income tax burden also increases. The higher the income, higher is the tax rate. People want to minimise the tax liability in legal ways so as to have more of their hard earn money in their hand. The government has also given certain ways through which everyone can save tax. Mutual funds also enjoy certain taxation benefits. One can invest in equity mutual fund or debt mutual fund depending upon his or her risk bearing capacity, age, time horizon, financial goal etc. In this post we will have a look at debt funds taxation.
Let us understand more about taxation of the debt mutual fund.
How are debt funds taxed
There are various kinds of debt fund namely, Short term, Fixed Monthly Plan, Ultra short-term, liquid and gilt fund. The taxation of all kind of debt funds is similar.
The returns from funds are characterised short term and long term. In case, of debt mutual fund, if a unit of debt mutual fund is held by an investor for more than 36 months from the date of unit purchase, then it is to be considered as long-term capital gain. On the other hand, if units are sold within 36 months from purchase, then it is considered as short term capital gain.
The holding period of 3 years based on which gain or loss classified as the long or short term was introduced in budget 2013-14. Before this, long term was considered if holding of funds for more than 1 year and less than 1 year classified as short-term capital gain. Also in case of long-term capital gain, the
In case, of short-term capital gain, the investor has to pay tax as per the applicable income tax slab. Such gain will be added to total income and accordingly tax limit is ascertained. For example, Mr. X is in the tax slab of 10% and if there is short term capital gain then he has to pay tax @ 10% on such gain.
While in long-term capital gain, the investor has to pay tax @ flat 20% of the gain with the benefit of cost indexation. Which means the absolute gain of investor will reduce by taking into effect the inflation rate. This will eventually reduce the income or gain which is liable for the tax. Previously before the introduction of budget 2013-14, the rate for long-term capital gain was 10%.
Just to sight more focus on and bring more clarity, I am going to explain this with a hypothetical example.
Tax on Short-term capital fund
An investor invested Rs.50,000.00 in debt fund on April 10, 2013, & remain invested till March Feb. 2014. He is in the tax bracket of 10% for Financial Year 2013-14. Suppose Sunil received Rs. 5500.00 as the return from debt fund. This income from debt fund will be added to his salary and will be taxed at 10% rate. So Rs.550 was the amount he had to pay as tax.
Tax on Long-term capital fund
In the above example, had the amount of Rs.1,00,000.00 remained invested from April 10, 2011, to April 26, 2014. The return he earned from such investment was supposed Rs. 29000. Now this gain is considered as long-term capital gain and will be taxed at the rate of 20% with indexation benefit.
Taxation of dividend on debt funds
It is important to note that dividend received from debt fund is tax-free in the hands of a unit holder of the debt fund. On the other side, the company has to pay Dividend Distribution Tax (DDT) before distributing the dividend. It should be noted that such DDT portion comes from NAV of units and hence after declaring dividend the NAV of the fund reduces.
What is considered as redemption
It is very important to note that whenever investor is making transaction wherein units of debt fund goes out from the holding is considered as redemption. So one has to be careful in cases of a switch over from growth option of dividend option or from one plan to another plan or changing plan from systematic withdrawal or transfer. All such transactions are considered as redemption and necessary taxation will be applied.
It is very simple and clear that taxation of mutual funds comes into the picture as and when units of mutual funds are sold. In the case of a debt fund, when units are sold within 3 years from the date of purchase; its gain is considered as short term capital gain and while units are sold after 3 years from purchase date is called long-term capital gain. Investors in the higher tax bracket are advisable to hold the units till 3 years because if the units are sold within 3 years then the tax rate will be applicable which is increase the outlay of tax. On the other hand investors with 10% to 20% tax bracket will not have the significant tax impact. Moreover, the dividend from debt fund is tax-free.
How Debt Funds work ?
Debt funds are mutual funds managed by professionals with their money invested in high-rated securities. Just like you lend money to the bank through fixed deposit or while purchasing the bond, a certificate is issued by the borrower. Debt funds also work on the similar concept. We will explore how debt funds work in detail in this post.
Small investors invest their money with the fund house which in turn pools the money and professional fund managers then invest such large amount in high rated securities like government or state government securities, commercial papers, Certificate of deposits, treasury bills etc. An individual cannot invest in such securities but fund house can. Even big businesses also issue their bond wherein individual investor will not be in a capacity to invest but since fund houses have a huge corpus to invest, they can invest into such bonds as well.
Fixed deposits are not transferable or tradable while the bonds in which debt funds invest are freely tradeable and hence it gives them a facility to switch if they do not perform as per the expectation of fund manager. Just like stock market wherein anyone can buy and sell shares; likewise there is a secondary market where bonds freely exchange. Also, the prices or NAV of the fund may rise or fall. There are various factors for the same, it may be due to interest rate change, changes in stock market etc. If for example, the mutual fund has invested in a bond and its prices go up over the period of time then the fund NAV or prices will go up accordingly. On the other hand, the return may go down which will, in turn, reduce the NAV.
As far as taxation of the debt fund is concerned, if an investor holds debt fund for a period more than 3 years then he will pay tax at the rate of 20% flat on the capital gain. Due to indexation benefit, the actual tax outgo will be less than 20%.
By investing in debt fund systematically and for considering long horizon, the fund can outperform in long run and gives far better returns. I hope the post give you a fair idea on how debt funds work and how you can analyse them for investing you hard earned money.