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Why invest in debt mutual funds

October 23, 2009 15:38 IST
Debt mutual funds invest in debt instruments like government bonds, fixed deposits and approved private deposits. There are rating agencies that grade the debt instruments. Based on the fund philosophy, the fund manager will choose the instruments with different risks.

Current income

The debt mutual fund is primarily focused on getting a regular return. The investments of the fund are in deposits/bonds with different maturing tenures and different interest rates. We need to take care to match our time frame for investment to the time frame of these. The current income from these funds will be in the range of 8 to 10 per cent.

Generally, the current income is received format the debt mutual funds in the form of dividend. Hence, this cash flow is tax free in our (investors') hands.

Capital appreciation

Through investing in debt instruments only, there is a possibility for capital appreciation in debt funds. This is a major advantage that we get from investing in mutual funds rather than directly in a bank deposit.

This capital appreciation is possible because debt instruments that mutual funds invest in are market tradable. Thus, when the market interest rates come down as in the current scenario, the debt mutual funds get much higher bond yield.

The average return from the top 15 debt mutual funds in the last one year has been 25.96 per cent.

Risk

When the interest rates go up in the general market, the bond yield comes down, leading to capital erosion when debt instruments are traded. This can lead to very low or even negative returns from debt instruments.

So no financial tool can be said to be risk free. However in the short term, debt instruments are a good place to preserve capital.

Liquidity

Debt funds have high liquidity. They can be converted to cash between 2 to 4 days. The high liquidity and conservation of capital are key benefits for temporary parking of funds. Many companies make use of these features for the cash management of their corporate funds.

Tax treatment

Debt mutual funds like the debt instruments are taxed higher then the equity mutual funds. The short term capital gains are taxed at 20% and the long term capital gains tax is 10%. The tenure for long term capital gains is an investment period of over 1 year (365 days). (Similar to equity mutual funds)

Convenience

Like any mutual fund, the debt mutual fund also gives the 4 conveniences:

Convenience of knowledge
Convenience of time
Convenience of small investments and
Convenience of payment frequency

Summary

Debt mutual funds score better than the debt instruments directly because of the tax benefits that we get from their dividends compared to interest from the debt instruments.

Preservation of capital is a major advantage that we get from the debt mutual funds. The potential for capital appreciation and higher returns that the traditional debt instrument can be maximised from these funds.

By nature of their investments and the tax treatment, these are for investment for the short term only.

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