Debt funds are fixed income mutual fund schemes which invest in debt and money market instruments like CPs, CDs, Corporate Bond, T-Bills, G-Secs etc. These instruments pay interest (coupon) at pre defined intervals and the face value (principal) upon maturity. The yields of many of these instruments are usually higher than bank FD interest rates of similar maturities. Yields of AAA rated corporate bonds can be 150 – 200 bps higher than FD interest rates. In addition to higher yields, since these instruments are traded in the market, you can benefit from price appreciation. The chart below shows the trailing returns of different debt fund categories over different tenures.
Based on historical data, you can see that across different product categories (risk profiles) and investment tenures, debt funds have the potential to give better returns than bank FDs.
Past performance may or may sustain in future. The returns shown above are returns of the category and do not in any way depict the performance of any individual scheme of any Fund.
Bank FD interest is taxed as per the income tax rate of the investor. Capital gains in debt funds held for over three years are taxed at 20% after allowing for indexation benefits. Indexation benefits can reduce tax obligations substantially for investors in higher tax brackets. Incidence of taxation in fixed income funds arise only if you redeem (sell) your mutual fund units or if you receive dividends. Capital gains on your redemption proceeds and dividends are taxed differently.
There are two kinds of capital gains in fixed income funds:-
Illustration of Long Term Capital Gains-
If you received the same maturity amount from a bank FD, then your tax outdo would have been Rs 8,280 if you were in the 30% tax bracket (plus surcharge & cess). The long term capital gains tax in the example above is nearly 60% less.
Prior to this financial year, mutual fund dividends were tax free in the hands of the investors but the scheme (AMC) had to pay dividend distribution tax (DDT) at the rate of 29.12% for debt funds before paying dividends to investors. In this Union Budget, the Government has abolished DDT. Dividends will now be added to your income and taxed as per your income tax slab. If you are in the 30% tax bracket, your post tax dividend will now be lower (assuming same dividend payout rate per unit), but if you are in the lower tax brackets your post tax dividends will be higher. You should decide whether to invest in growth or dividend re-investment option depending on your individual tax situations.
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