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Debt Mutual Funds: Should You Still Invest Without Indexation Benefits?

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Debt Mutual Funds

With the Indexation benefits in Debt mutual funds stopped, investors are reevaluating their investment portfolios from the taxation standpoint. The indexation edge was one of the key motivations for investors looking for safer assets to beat inflation. Investors are curious whether to continue debt investment or shift to traditional vehicles such as FDs in light of the proposed changes in the Finance Bill.

We look at Debt Mutual Funds and attempt to answer every possible question possible.

What is Debt Funds?

Debt Mutual Funds are the category of mutual funds where the funds are invested in fixed-income securities like Treasury bills, Bonds, Debentures, Corporate bonds, Commercial papers, government securities, securitized debts, certificates of deposits (or CDs), and other money market instruments.

Debt Mutual Funds are categorized as low-to-moderate-risk investment options and are also popular as fixed-income or bond funds. Such funds are less volatile and hence less risky than equity funds and invest at least 65% of the assets in debt or debt-linked products.

Types of Debt Mutual Funds

Debt Mutual funds are classified into 16 varieties, broadly divided into security- and duration-based debt funds. We’ve gone over some of the most popular types-

Liquid Funds

Liquid funds invest in liquid assets and debt securities with no more than 91 days of maturity. These high-liquidity funds typically invest in treasury bills, commercial papers, and collateralized obligations. Most appropriate for idle parking funds or emergency funds that earn low interest in your savings account and can be invested for as little as one day.

Ultra-Short term funds

Debt mutual funds in this category are generally invested in a wide range of short-duration debt and money market securities with maturities ranging from three to six months. As a result, these funds are ideal for corporate and retail customers seeking short-term investment opportunities for idle or surplus funds.

Low/Short/Medium Duration Funds

Low-duration funds are debt mutual funds that invest in debt and money market instruments with maturities of six months to a year. Short-term funds invest in corporate and government bonds that mature in one to three years.

Medium-duration debt mutual funds have portfolio durations ranging from three to four years. They are the preferred investment option for investors who benefit from decreased interest rates or higher yields.

Corporate Bond Funds

This type of Debt mutual fund invests at least 80% of its assets in corporate bonds with AA or higher credit ratings.

Fixed Maturity Bonds (FMPs)

Fixed Maturity Plans, or FMPs, are closed-ended debt funds that generate income by investing in debt, money market instruments, and government securities with maturities corresponding to the bond’s maturity. The best investment option for investors who want to earn interest while taking on a little risk.

GILT Funds

At least 80% of investment is made in sovereign securities issued by the Central or the State government to generate credit-risk-free returns. 

Benefits for Those Who Invest in Debt Mutual Funds


Debt mutual funds are the easiest way to diversify your investments across multiple asset classes while minimizing investment risks, even if you don’t understand everything about each one. The most significant advantage of diversification is that your investment becomes significantly less vulnerable to market volatility and economic turmoil.

Generate Regular Income

You can use systematic withdrawal plans (SWP) mode in debt mutual funds to generate regular cash flow and meet your financial needs. You can easily withdraw money at regular intervals through this facility to meet your everyday expenses. In addition, dividend income can also be earned as a steady source of income if the debt fund’s portfolio contains high-dividend-paying assets.

Gain from Falling Interest Rates

The returns on debt mutual funds are inversely related to interest rates. When interest rates fall, bond coupon rates rise, yielding higher returns in contrast to the return trajectory of other asset classes. As a result, when equity and fixed-income investors experience lower returns, the value of your portfolio rises.

Setting-off losses

The government allows capital gains to be offset against long-term capital losses. As a result, you can use the long-term capital loss on your debt funds to offset your equity gains.

Tax Deferred

You can defer paying taxes on your investment gains on Debt Mutual funds until you redeem your units. When capital gain tax is calculated and payable only at redemption, you can better manage your liquidity and finances.

Debt Mutual Funds – Old vs New Taxation Norms

Let us learn why Debt Mutual Funds under the old tax regime were considered more tax efficient than traditional Bank fixed deposits through the table below-

CriteriaOld TaxationNew Taxation w.e.f 01st April 2023
Short-Term Capital GainIf the debt mutual fund units are sold off after three years, a 20% tax will be applicable.If the debt mutual fund units are sold off before the completion of three years, the gains are taxed as per Investor’s tax slab.
Long-Term Capital Gain (LTCG)Capital gains from Debt Mutual Funds can be offset by capital losses from other investments.
Indexation BenefitAllowedNot Allowed
Setting-off LossesTax on the interest is payable every year irrespective of the maturity of the deposit.No such advantage
Tax Deferment BenefitTax on debt mutual funds can be deferred till the redemption of the units.Tax on the interest is payable every year, irrespective of the maturity of the deposit.

How are Debt Mutual Funds different from Fixed Deposits?

With the recent removal of the indexation benefit from Debt Mutual Funds held for more than three years, which was the primary motivator for debt investments, there has been a raging debate about which is better- Debt Mutual Fund or FD.

 Look at the table below to understand the differences between Debt Mutual Funds and traditional fixed deposits.

CriteriaDebt Mutual FundsFixed Deposits
ReturnsFixed deposits offer guaranteed returns unaffected by macro or microeconomic factors.Fixed deposits offer guaranteed returns that are not affected by macro or microeconomic factors.
RisksExposed to Low to Moderate RisksFixed Returns and Minimal Risk
LiquidityHighly liquid and can be redeemed at any time with or without exit load (Some fund houses may charge a nominal exit load of about 1%).Low as premature withdrawal extract a penalty ranging from 0.5 to 2% in most Banks.
Systematic Investment FacilitySIP in Debt Mutual Funds allows you to benefit from the power of compounding. It also assists you in systematically growing small contributions into a large corpus.Only lump-sum investments are allowed in Fixed Deposits.
Expense RatiosExpense ratios charged by fund houses for handling the debt mutual funds may vary from 0.2% to 2.25%.No such management charge is imposed by Banks.
TDSNo TDS payableTDS is deducted if the annual interest received exceeds Rs. 40,000/- (Senior Citizens- Rs. 50,000/-) in a financial year.
DividendPaid depending on the type of debt fund Not paid

Wrapping it Up

When interest rates fall, debt mutual funds thrive. Surprisingly, this is correct. For example, consider the average returns of debt funds in the fiscal year 2022-23, when even the most robust economies were coping with inflationary pressures, recessionary fears, a chaotic global political arena, and much more.

To combat uncontrollable inflation, the RBI increased repo rates regularly. Unfortunately, this bleak economic equation further weakened the debt mutual fund returns; see the data below.

image 9

Debt Mutual Funds have lost their sheen and still rank the best for meeting short-term financial goals. Pick your investments cautiously, keeping an eye on factors like liquidity, market scenarios, Risk-adjusted returns, expense ratios, exit load, investment horizon, risk tolerance, tax outgo, and other vitals.


Which is better- Equity or Debt Mutual Fund?

There is no single recipe that works best for everyone. Tax considerations should not be the sole determinant of your investment decisions. The decision is influenced by various factors, including risk tolerance, investment horizon, overall financial goals, and patience. For example, if you are easily overwhelmed by market volatility and react to fluctuations, investing in debt mutual funds rather than equity is better.

Can Debt Mutual Funds underperform traditional schemes of investment?

Debt mutual funds can underperform and even deplete your invested capital. Yes, you heard correctly. Though debt mutual funds are considered safer investment vehicles than equity, they are subject to various risks, including credit, interest rate, inflation, and other inherent risks.
So, pick the best debt mutual fund, considering the credit rating, maturity, safety, liquidity and competitive risk-adjusted returns before investing.

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