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.
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.