What Are Short-Term Debt Mutual Funds? How Are Dividends Taxed?

Short-term debt funds, also called short-term income funds, could offer investors modest returns during a rising interest rate scenario due to their low volatility. These funds typically have a maturity period of one to three years and invest mainly in government and corporate bonds like commercial paper, floating rate bonds, debentures, non-convertible debentures, term deposits, and central government loans. 

These debt instruments have high credit ratings as their chances of going default are low.

Benefits of Short-Term Debt Fund

Interest Rate Impact

Short-term debt funds are less vulnerable to interest rate movements since their investments in bond and debt instruments are short to medium-term, offering stability to the portfolio during volatile interest rate periods. The risks due to interest rate fluctuations are, therefore, minimal.

For example, suppose your mutual fund has invested in a debt instrument that expires on June 2023, and the Reserve Bank of India (RBI) reduces the interest rate after maturity. The fund won’t lose the interest earnings since the bond has matured and the interest is paid. 

Debt funds also offer portfolio diversification since they invest in instruments with different maturity periods, thus offering a cushion against the rise and fall of interest rates. Hence, these funds could be perfect for investors with a low-risk appetite.

Withdrawal Flexibility

Debt funds offer higher liquidity as investors can withdraw their investments within two working days.  

Dividends

Short-term debt funds have the option of dividend payments. Investors can earn regular dividends, typically monthly or fortnightly. However, individual investors must pay the Dividend Distribution Tax (DDT).

How They Fair With Bank Fixed Deposits

Due to taxation benefits, short-term debt funds generally offer higher returns than bank fixed deposits (FD). For example, unlike interest collected on bank deposits, which are taxed, earnings on short-term debt funds with a maturity of more than three years attract lower taxes.

Taxes On Debt Fund

Long-Term Capital Gain

A long-term capital gain tax will be applicable if the debt mutual fund units are sold after three years. In this case, the applicable tax rate is 20 per cent, along with indexation benefit, which considers inflation. Returns generated from the sale of debt fund units are not subjected to Securities Transaction Tax (STT), which is 0.001 per cent.

Short-Term Capital Gain

If the debt mutual funds units are sold before three years, they will attract short-term capital gain tax. Returns from the sale of mutual funds units will be taxed as per the investor’s income slab, plus cess charges.

Risks                                      

Debt mutual funds usually invest in securities with high credit ratings and a strong safety track record. Investors, therefore, should always check the credit ratings of bonds and debt instruments where the mutual fund is investing.