How Debt Funds Work?

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Short Answer

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.

Detailed Answer

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.

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Categories: Mutual Funds
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Debt funds are a type of mutual fund that primarily invests in fixed-income securities such as government bonds, corporate bonds, treasury bills, and other debt instruments. They are designed to provide regular income and relatively lower risk compared to equity funds. Debt funds work by pooling money from multiple investors and investing it in a diversified portfolio of debt securities. The fund manager selects and manages the securities in the portfolio based on the fund's investment objective and strategy. The underlying debt instruments generate interest income, which is passed on to the investors in the form of periodic dividends or interest payments. The key features and workings of debt funds are as follows: Investment Objective: Debt funds aim to generate income and preserve capital by investing in fixed-income securities. Risk and Returns: Debt funds are generally considered less risky than equity funds, but they still carry some level of risk. The risk depends on factors such as credit quality, interest rate movements, and liquidity of the underlying securities. Returns from debt funds come from interest income and any capital appreciation of the securities. Diversification: Debt funds diversify their portfolio across various issuers, sectors, and maturities to spread the risk. This diversification helps reduce the impact of defaults or credit risks associated with individual securities. Interest Rate Sensitivity: Debt funds are sensitive to changes in interest rates. When interest rates rise, the value of existing fixed-income securities in the portfolio may decrease, leading to a decline in the fund's NAV (Net Asset Value). Conversely, when interest rates fall, the value of existing securities may increase, positively impacting the NAV. Types of Debt Funds: Debt funds offer different types such as liquid funds, short-term funds, corporate bond funds, gilt funds, and dynamic bond funds. Each type has specific investment objectives and risk profiles, catering to different investor needs. Expense Ratio: Debt funds charge an expense ratio, which covers the fund's operating expenses. It is important to consider the expense ratio while evaluating the fund's returns. Taxation: Debt funds are subject to taxation based on the holding period. Short-term capital gains (holding period less than 3 years) are taxed at the individual's applicable income tax rate, while long-term capital gains (holding period more than 3 years) are taxed at a flat rate with indexation benefits. Debt funds provide an avenue for investors to earn regular income and potentially benefit from capital appreciation while managing risk. It is advisable to assess the investment objective, risk profile, and investment horizon before investing in debt funds. Consulting with a financial advisor can help in selecting the right debt fund that aligns with individual financial goals and risk tolerance. To start investing now, visit

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