Debt index funds are tax efficient way of earning predictable returns

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Most of us have heard about passive investing, in which you do not track a stock instead you invest in an underlying index such as Sensex and Nifty. The good news is now you can do passive investing in debt as well considering many mutual fund houses have launched their own debt index funds. These funds broadly invest in government securities, state development loans, treasury bills and AAA PSU Bonds. They are target-date index funds with a limited tenure with near-zero credit risk. But like equity index funds which have defined benchmarks such as Sensex and Nifty they have customised benchmarks and usually track the Crisil debt indices as their underlying indices.

Consider this: Edelweiss Mutual Fund has recently launched a NIFTY PSU Bond Plus SDL Index Fund – 2026, which invests in debt papers of AAA-rated public sector papers and state development bonds (SDL).  The fund will mature in 2026. Similarly, IDFC Mutual Fund has launched the IDFC Gilt 2027 Index Fund and the IDFC Gilt 2028 Index Fund. Both G-sec index funds invest in government securities and are benchmarked against two gilt indices – CRISIL Gilt 2027 and 2028 indices.

“There are multiple USPs of investing in debt index funds. One is the portfolio construct, which comprises government securities, state development loans and AAA PSU bonds. So credit quality is definitely very good. It follows an index so there is no fund manager call. And lastly, there is something called maturity rolled off, which means every passing day the remaining maturity comes down. The remaining market risk progressively comes down so that at maturity, there is no market risk at all,” said Joydeep Sen, debt market corporate trainer.

How much return debt index funds offer?

The debt index funds give you a predictable but not guaranteed return. Since they have fixed maturity, the yield to maturity or YTM is a good indicator. “In these kinds of funds, your YTM is a reasonably good indicator. So what the investor can do is simply look up the website of the fund and look at the portfolio construct. So, as an example, if the YTM is say 6%, you can reasonably expect something around 6% return. Whereas in a regular fund, if the YTM is 6% you may get 7%-8%. So, there’s a high degree of uncertainty. Whereas here you have a high degree of certainty. Just look up the YTM on a website. You can just look at the fund fact sheet for the YTM data,” said Sen.

So, if you invest in target-date index funds and go through this passive investing route, it will be much simpler for you to know what you will get by looking at the yield to maturity. If you are holding it till maturity, you will get the initial YTM of the fund.

How tax-efficient are debt index funds?

If you stay invested for a long tenure, debt index funds are tax-efficient ways for investors in high tax brackets compared to fixed deposit. As with debt funds, you pay 20% tax with indexation for long term capital gains. Short term capital gains are added back to your income and taxed as per your income tax slab. If you hold a debt fund for less than 3 years it is classified as short-term. If a debt fund is held for more than 3 years it is classified as long term. This makes debt index funds tax efficient as the interest rate from FD is taxable as per your tax slab rate.