Executive Summary:  Debt Mutual Funds invest in bonds, treasury bills and other money market instruments. Debt MFs are less volatile and therefore less risky as compared to Equity MFs. They have potential to give returns that can beat inflation. There are different types of Debt MFs. When interest rates are expected to fall, one can invest in long term debt funds and when interest rates are expected to rise, one can invest in short-term debt funds.

​A debt mutual fund is a fund that invests money in different bonds and deposits and earns interest on them. They lend money to different companies that issue bonds or have deposits and earn interest on the loan. This interest is then distributed to the debt fund investors. The schemes also earn by way of capital appreciation.
Key Features 

• Debt Funds invest in GoI bonds, corporate bonds, Treasury Bills and Money Market Instruments which have different credit ratings.
• There are different types of debt mutual funds – Bond funds, Liquid funds, Income funds, Short-term funds, Ultra short-term funds, Gilt Funds, FMPs. The differentiation lies in the type of underlying investment instruments, maturity period of the underlying securities and offer period.
• They are less volatile than equity funds. They are less risky as compared to equity mutual funds. The returns are generally lower than that of equity funds.
• You can invest in Debt Funds either in a lump sum manner or via the SIP route. Similarly you can withdraw money as a lump sum amount or using the SWP route.

​Advantages of Investment in Debt Funds

• Debt Mutual Funds are more stable compared to equity mutual funds and less volatile.
• They are highly liquid. You can withdraw your money when you want unlike Fixed Deposits of PPF from most debt mutual funds. Close-ended schemes will not allow it. Some might have exit load for a certain duration. But overall Debt MFs are more liquid compared to other investment options.
• You have the potential to earn returns above the inflation rate as you earn dividend and capital appreciation.

Disadvantages of Investment in Debt Funds

• The returns potential is lower as compared to equity funds
• You will have to bear costs related to management fees.
• Investors are exposed to risks due to bankruptcy or defaulting of payments  of concerned institutions.
• Debt MF Schemes are exposed to interest rate risks. When interest rates go higher, the bond prices go down which means the investment value can become lower. When interest rates go low, the instruments might earn lower returns.
• There is no guarantee of capital protection or fixed returns.

Tax Regulations on Debt Funds

• Redemption of debt fund schemes within 3 years of initial investment is considered as short-term investment. The gains are therefore considered as short term capital gains. In this case, will be taxed at the income tax slab rate that is applicable to you.
• Gains from debt Mutual Fund schemes redeemed after 3 years are considered as long term gains. Such gains are taxed at 20% rate after indexation. Dividends are taxed for the Asset Management Company.

When to Invest in Debt Funds

• Investment in debt funds face risks related to interest rates. You should invest in long-term funds  when you are young. When you are reaching retirement, transfer majority of the investment in a liquid fund or an ultra short-term debt fund as they are less reactive to changes in interest rate structures 
• When interest rates are expected to fall, the bond prices will rise. If you invest at this time in long-term debt funds, your capital will appreciate well. 
• When interest rates rise, the interest rate earned by short-term debt funds will rise. So if you expect interest rates to rise, invest in short-term debt funds.
• To have a balanced investment portfolio, invest in debt mutual funds depending on your financial goals and financial situation.

Why to Invest in Debt Funds
Debt Funds are suited for conservative investors. They are tax-efficient in the long-run. They are liquid. It is good to invest in debt funds for goals such as funding for child’s education or funding some portion of the retirement fund. If you have any medium-term funding requirements like your child’s marriage or your marriage in 3-5 years, debt funds are ideal. They give better returns than fixed deposits.

Performance of Some Debt Funds
Here are some debt funds and their performance to give some insight into the returns that can be expected –