Types of Debt Mutual Funds

Debt Funds come in several types that cater to the different needs of the investors in India. Explore different types of debt mutual funds in this blog.
Types of Debt Mutual Funds
4 mins
9 January 2024

Debt funds represent a category of mutual funds that primarily invest in fixed-income securities, offering investors an avenue to earn returns through interest income and capital appreciation. Unlike equity funds, which invest in stocks, debt funds deploy capital into a spectrum of fixed-return instruments such as government bonds, corporate bonds, treasury bills, commercial papers, and other debt instruments. The primary objective of debt funds is to generate stable returns while preserving capital.

Investors find debt funds appealing for several reasons. Firstly, they provide a diversified portfolio of debt instruments, mitigating the impact of individual security defaults. Secondly, debt funds tend to be less volatile than equity funds, making them an attractive option for risk-averse investors seeking steady income.

Debt funds offer a range of categories to meet different financial goals. These include liquid funds, ideal for short-term needs, and long-duration funds, suitable for those with a more extended investment horizon. Whether you are seeking capital preservation, regular income, or a combination of both, debt funds offer a versatile investment avenue within the broader landscape of mutual funds.

Types of debt mutual funds

  • Liquid funds: Liquid funds are characterised by their short investment horizon, typically investing in money market instruments with maturities of up to 91 days. These funds offer high liquidity, making them ideal for investors with short-term financial goals.
  • Money market funds: Money market funds focus on short-term debt instruments with a maximum maturity period of one year. They strike a balance between safety and returns, making them suitable for conservative investors.
  • Dynamic bond funds: Dynamic bond funds provide fund managers with flexibility to adjust the portfolio duration based on interest rate movements. This adaptability allows them to capitalise on market fluctuations.
  • Corporate bond funds: Corporate bond funds predominantly invest in debt instruments issued by corporations. They offer relatively higher returns than government securities but come with an associated risk.
  • Banking and PSU funds: These funds invest in debt instruments issued by banks and public sector undertakings (PSUs), combining safety with reasonable returns.
  • Credit risk funds: Credit-risk funds allocate at least 65% of their total assets to corporate bonds rated AA or lower. Taking on higher risk by investing in lower-rated securities, credit risk funds offer the potential for higher returns, but investors must be cautious about the associated credit risks. For investors open to accepting a greater risk of default, credit-risk funds present an option worth considering.
  • Floater funds: Floater funds invest at least 65% of their assets in floating-rate bonds, which adjust interest rates based on prevailing market conditions. This dynamic feature helps in managing interest rate risk.
  • Overnight funds: Overnight funds allocate investments to securities with a one-day maturity, predominantly in money market instruments. The primary objective of these funds is to offer liquidity and convenience rather than pursuing substantial returns. They prove to be a fitting choice for investors, particularly corporate treasuries, seeking to temporarily park funds for very brief periods.
  • Ultra-short funds: Ultra-short funds strike a balance between liquid and short-term funds, with a focus on minimising interest rate volatility. These funds are suitable for investors with an investment horizon on three to six months.
  • Low duration funds: Low duration funds are a category of debt mutual funds that invest in debt and money market instruments with a duration of six months to a year. These funds aim to provide a balance between safety, liquidity, and moderate returns. They are suitable for investors with a short to medium-term investment horizon who are looking for better returns than traditional short-term investment avenues.
  • Medium duration funds: Medium duration funds invest in debt securities with a duration typically ranging from three to four years. These funds aim to strike a balance between risk and return, making them suitable for investors with a moderate risk appetite and a medium-term investment horizon. The portfolio is structured to capture opportunities arising from interest rate movements within this time frame.
  • Medium to long duration funds: This category spans a broader range of durations, typically between four to seven years. Medium to long duration Funds aim to balance the need for higher returns with the associated interest rate risk. Investors with a slightly longer investment horizon and a willingness to accept moderate risk may find these funds suitable for their portfolios.
  • Long duration Funds: Long duration funds invest in debt instruments with a duration exceeding seven years. These funds are geared towards investors with a longer investment horizon who are willing to bear the potential impact of interest rate fluctuations in pursuit of higher returns. Long duration funds may be suitable for those with a patient approach and a view on interest rate movements over an extended period.


According to the most recent income tax regulations, both Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG) derived from mutual funds are now subject to taxation based on your individual income tax slab. Notably, debt funds no longer enjoy the benefit of indexation for taxation purposes, and these regulations are applicable to investments made after April 1, 2023.

However, the taxability scenario differs for investments made before April 1, 2023. Here are the specifics:

In the case of Short-Term Capital Gain (STCG), if you choose to remain invested in debt mutual funds for a period not exceeding 3 years and realise capital gains upon redemption, these gains are considered as STCG. They are then added to your overall income and subjected to taxation in accordance with your respective income slab.

Conversely, if you redeem your investment after a duration of 3 years and you have received gains, it is categorised as Long-Term Capital Gain (LTCG). These gains are subject to a flat tax rate of 20%, and investors can benefit from indexation to account for inflation, providing a nuanced approach to taxation for those with long-term investment horizons.

Tax laws are subject to amendments made to it from time to time. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax and/or investment advice. Please consult your tax advisor, before making in any investment decision based on the above.

Why invest in Debt Mutual Funds? 

  1. Stability and Safety: Debt Mutual Funds primarily invest in fixed-income instruments, providing a stable and safer investment option compared to equity funds. The focus on government securities and high-rated corporate bonds contributes to stability.
  2. Predictable Returns: Debt funds offer relatively predictable and steady returns, as they are less influenced by market volatility. The interest rates on fixed-income securities determine returns, providing a sense of consistency.
  3. Diversification and Lower Risk: Investing in Debt Mutual Funds allows for diversification across various fixed-income instruments, mitigating risk. While not entirely risk-free, debt funds are generally considered lower risk compared to equity funds.
  4. Tax Efficiency: Debt Mutual Funds benefit from favorable tax treatment. Investments held for more than three years qualify for long-term capital gains tax with indexation benefits, reducing the tax liability for investors.
  5. Professional Management: Debt funds are managed by professional fund managers who specialize in fixed-income markets. Their expertise ensures informed decisions on portfolio composition and duration, optimizing returns for investors.

Risks associated with debt funds

Debt mutual funds come with two primary risks – Credit risk and Interest rate risk. Let us understand these risks and explore strategies to minimise their impact.

  • Interest rate risk: The foremost risk in debt funds stems from the fluctuation of bond prices based on prevailing interest rates. When market interest rates rise, existing bond values decline, impacting the Net Asset Value (NAV) of the fund. To mitigate this risk, it is prudent to opt for fund categories with shorter to medium durations, as interest rates tend to exhibit less volatility within these time frames.
  • Credit risk: This risk surfaces when a borrower defaults on interest and/or principal payments. Mitigating credit risk involves investing in debt funds that lend to highly-rated corporates, as indicated by credit agencies like CRISIL. A “AAA” rating signifies the lowest credit risk. However, it is crucial to note that while high-rated borrowers offer lower risk, they also yield lower interest rates.


Understanding the diverse range of debt funds in India is crucial for investors. Each category comes with its own set of features, risks, and potential returns. By aligning investment goals with the appropriate debt fund, investors can not only safeguard their capital but also witness steady wealth appreciation over time. It is imperative for investors to conduct thorough research, assess their risk tolerance, and seek professional advice to make well-informed investment decisions in the realm of debt funds.

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Frequently asked questions

How do debt funds work?

Debt funds pool money from various investors to invest in fixed-income securities like government bonds and corporate debentures. The returns are generated through interest income and capital appreciation.

Is debt fund good or bad?

Debt funds are suitable for investors seeking stable returns with lower risk compared to equities. They offer diversification and can be a good choice for short to medium-term goals. However, they may not provide as high returns as equities.

Are debt funds safer than FD?

Debt funds and Fixed Deposits (FDs) differ in risk and return profiles. While FDs offer capital protection, debt funds may have market-related risks. However, debt funds provide potential for better returns and tax efficiency compared to traditional FDs.

Who invests in debt funds?

Debt funds attract a range of investors, including those seeking stability, retirees, and individuals with short to medium-term financial goals. Conservative investors who prioritize capital preservation often choose debt funds.

Are debt funds tax-free?

Debt funds are not entirely tax-free. Gains from debt funds are subject to taxation. Short-term capital gains (holding period less than 3 years) are taxed at the investor's slab rate, while long-term gains enjoy indexation benefits and are taxed at 20%.

Which is the safest debt fund category?

Short-term debt funds typically carry lower risk due to shorter maturity durations, making them a safer option for investors seeking stability in their investments.

Which debt fund gives the highest return?

Long-term gilt funds, investing in government securities with longer durations, often offer higher returns among debt funds, but they also come with higher risk due to interest rate fluctuations.

How many types of debt mutual funds are there?

There are several types of debt mutual funds, including liquid funds, short-term funds, medium-term funds, income funds, gilt funds, and dynamic bond funds, each catering to different risk profiles and investment objectives.

Are debt funds taxable?

Yes, debt funds are subject to taxation based on the holding period. Short-term capital gains (holding period less than three years) are taxed at the investor's applicable income tax slab rate, while long-term capital gains (holding period more than three years) are taxed at 20% with indexation benefit.

Are debt funds safe?

Debt funds carry varying degrees of risk depending on factors such as the type of securities they invest in, their duration, and interest rate movements. While some debt funds offer relatively lower risk, no investment is entirely risk-free, and investors should assess their risk tolerance before investing.

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