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Debt Mutual Funds: Definition, Types, How To Invest, Returns, & Taxation

Debt mutual funds are investment instruments that cater to the need for risk-averse investing. These mutual funds primarily include only those securities that yield fixed returns. Moreover, unlike equity funds, the safety of the invested capital is ensured in debt funds.

The securities included in the debt fund’s portfolio consist of treasury bills (maturity of less than 1 year), government bonds (maturity of more than 1 year), corporate bonds, non-convertible debentures, etc.

Debt mutual funds can provide both regular income and capital appreciation. Depending on one’s investment goal, a suitable type of debt fund shall be selected. It means, not all debt securities are the same. There are different types of debt instruments ideal for different time horizons.

Debt funds do not strictly yield fixed returns, but as the variation in returns, standard deviation, is very low we can call them fixed-return securities. This low volatility also makes them suitable for income investing.

The most common debt instrument is the banks’ fixed deposits (FDs). Debt funds are better than FDs. Why? Because they not only yield slightly better returns than FDs but are also more tax-friendly. Hence the net return of debt funds is better than bank deposits.


Categories of Debt Funds

As per SEBI’s circular issued in 16-Oct’2017, different types of debt mutual funds have been categorized into sixteen categories. The categorization is done so that the investors exactly know what they are investing in.

SL Category Maturity Security Type (Min %)
1 Overnight Fund 1 Day Overnight Securities
2 Liquid Fund Upto 91 Days Debt & Money Market
3 Ultra Short Duration Fund 3 to 6 months Debt & Money Market
4 Low Duration Fund 6 to 12 months Debt & Money Market
5 Money Market Fund Upto 1 Year Money Market
6 Short Duration Fund 1 to 3 Years Debt & Money Market
7 Medium Duration Fund 3 to 4 Years Debt Schemes
8 Medium to Long Duration Fund 4 to 7 Years Debt Schemes
9 Long Duration Fund Above 7 Years Debt Schemes
10 Dynamic Bond Fund All Durations Debt Schemes
11 Corporate Bond Fund All Durations High Rated Corporate Bonds (80%)
12 Credit Risk Fund All Durations High Rated Corporate Bonds (65%)
13 Banking & PSU Fund All Durations Debt Schemes of Banks & PSU’s (80%)
14 Gilt Fund All Durations G-Secs (80%)
15 Gilt Fund (10-Yr) 10 Years G-Secs (80%)
16 Floater Fund All Durations Floating Rate Instruments (65%)

Selection of Debt Funds

The categories of funds defined by SEBI can become the basis for mutual fund selection for investors. There can be two approaches to the selection process.

  • Based on Holding Time: SEBI’s categories indicate the maturity periods of securities included in the mutual fund’s portfolio. The investors’ available holding time should match the maturity periods.
  • Based on Investment Goal: Investors can add debt securities to lower the volatility of their investment portfolio. People who invest primarily in equity can have a very volatile portfolio. Including long-term debt mutual funds will not only complement the portfolio theme but will also impart more stability.

Out of the above two, the majority of retail investors’ requirements will be met with the first approach. If the investor can define when the investment fund is required, it will decide the choice of suitable debt fund based on the above categories.

The volatility of Debt Mutual Funds

Yes, the NAV of debt funds is also volatile. But the volatility does not behave in the same way as equity.

  • In equity investing, volatility is maximum in short term and reduces with increasing holding time.
  • In debt investing, the relationship is the opposite. Debt funds whose average maturity period is longer tend to be more volatile than funds with shorter average maturity. Why it is so? The cause is the interest rates. How?

The attractiveness of a debt fund with longer average maturity can change multiple times during the holding period.

Suppose there is a debt fund whose average maturity of its holdings is 5 years. In these five years, there will be multiple times when RBI will change the repo rate (interest rate). Every time the repo rate is changed, it will affect the demand for the debt funds, hence its NAV.

Why does the demand for debt funds change with the interest rate? The main constituent of debt funds is Bonds. These bonds yield fixed returns.

Suppose there is a debt fund whose average maturity is 5 years and it yields a return of 7% per annum. At this time the repo rate set by the RBI is 5.9% per annum and the bank’s 10-Year fixed deposits yield 6.5% interest.

When the repo rate will rise, the interest rate offered by bank deposits will also increase. More investors will pick a bank deposit now. It will decrease the demand for debt funds, hence its NAV will fall. An inverse will happen when the repo rate falls. The demand for debt funds will increase and hence the NAV of these mutual funds will rise.

Right Time To Invest in Debt Funds

People often try to time their entry into equity. But is it possible, and useful, to time investments into debt funds? Let’s read more about it.

As explained in the above volatility chart, debt funds are more in demand when RBI is reducing the repo rate (interest rate). As interest rates fall, bank FDs will give lower interest rates. Prospective risk-averse investors who were earlier looking to buy the FD will look for alternative instruments for better returns.

What is the best alternative to bank FDs? Debt mutual funds.

Repo Rate – Historical data from the year 2005 to 2022 (16-Years)
Historical Repo Rate from 2005 to 2022 (India)

In the above historical repo rate chart, you can see the following:

  • Oct-2005 to Jul-2008: The repo rate rose consistently from 6.25% to 9.0%. As it is a rising interest rate scenario, bank FDs are becoming more lucrative. Hence, new investors would prefer FDs over debt mutual funds. In such times, the NAV of debt funds will fall. Not a good time to buy debt funds.
  • Jul-2008 to Mar-2009: The repo rate fell from 9.0% to 4.75%. In such a falling interest rate scenario, people will seek to invest in debt funds for higher returns. Hence, the demand for debt funds will increase leading to rising NAV. A good time to buy debt funds.
  • 2010 to 2014: The repo rate kept climbing and it again touched 8% levels. It was the phase where bank FDs were offering 10-11% returns. The demand for debt mutual funds was only falling in this period.
  • 2014 to 2020 (Pre Covid): The new government at the center was keen on driving consumption. The repo rate kept falling from 8% levels to 4% levels. Inflationary concerns were also not there. Falling repo rates meant good demand for debt funds.
  • 2020 to Apr-2022 (Covid Phase): The repo rate remained constant at 4% levels. But there was less demand for debt funds as the stock market was playing most bullish in this period. Everyone was only equity-focused.
  • Apr-2022 to Oct-2022 (Today): The interest rates are rising again. The concern is inflation. It is again not good for debt funds. In an inflationary market, interest rates rise, and most people try to avoid debt-linked investments altogether.
Repo Rate vs. Mutual Fund NAV 2005 to 2022 (16-Years)
Repo Rate Vs NAV of Debt Fund (Historical Data from 2005 to 2022)

This chart is comparing the performance of a debt fund’s NAV with the repo rate. It is HDFC’s Dynamic Bond fund. Overall, the NAV of this debt fund has risen from Rs.23 levels to Rs.73 levels between 2005 and 2022. It is showing an annualized growth rate (CAGR) of 7.2% per annum.

You can see the minor jumps in the NAV during the phase when repo rates were lowered. In the overall performance of the debt fund, these boosts only look like blips, right?

What does it tell us? Had these blips been more dominant, one could have thought of timing the debt funds. But for such minor gains, I think it’s not worth taking the pain to time a debt fund.

If one really wants to see the gains of market timing, equity will provide more excitement. If you are a long-term investor buying debt funds, you are mainly doing it for portfolio stability. For you, but a suitable scheme and just hold on to it (say 10-Years). In India, a 7% plus return is possible.

Note For a long-term investor: Buy a debt fund when it is not in demand (falling NAV). Check the repo rates. If it is rising, it is a hint that the NAV of debt funds will start falling. Accumulate debt funds and hold on to them for the next 10-15 years. Seven percent plus the return is not impossible. Moreover, it will also decrease the volatility of your investment portfolio.

Best Debt Mutual Funds for Long-term Investors

The portfolio of a long-term investor is mostly equity-heavy. Why? Because quality equity assets can offer higher returns. Such investors also include debt-based assets in the investment portfolio. The easiest debt-based asset is the bank’s FD. But their yield is low. Debt funds can give better yields with almost the same levels of stability.

For long-term investors, the following debt funds are suitable.

  • Dynamic bond funds
  • Gilt Funds
  • Banking and PSU funds.
  • Credit risk funds.

Check the above category table for a better idea.

Debt Funds To Park Emergency Savings

We cannot park our savings meant to deal with emergencies of life. Why? Because we do know when we’ll need it. Debt mutual funds become a reasonable choice to park our emergency savings. There is a rule to allow investments for our investment savings. We must assume that we may need these funds in the next year.

The following two types of debt funds are suitable for this purpose:

  • #1. Money Market Fund: I will park my savings allotted for emergencies in a money market fund. A typical money market fund’s portfolio will look like this. T-Bills (25%), High Rated Corporate Bonds (25%), Corporate Money Market Securities (40%), and Fixed Deposits & Cash (10%). The average maturity period of securities in a money market fund is typically 6 months. The NAV of these funds normally grows at a CAGR of 7% per annum. Check the below chart for the performance of the ICICI Pru Money Market Fund. The minimum investment in this debt fund is Rs.5000 (lump-sum) and Rs.1000 (SIP).
Money Market Fund - NAV History
  • #2. Liquid Fund: These funds are also suitable to park emergency savings. The portfolio of a liquid fund will look like this. Commercial Papers (50%), Certificate of Deposits (20%), T-Bills (20%), Bonds and Non-Convertible Debentures (5%), and Others (5%). The average maturity period of securities in a liquid fund is typically 7 days. The NAV of these funds normally grows at a CAGR of 7% per annum. The minimum investment in a liquid fund is typically Rs.100 (lump-sum 7 SIP).

Expected Returns From Various Types of Debt Funds

Here is a list of 16 types of debt funds as categorized by SEBI. A typical return generated by schemes in each category, in the last 20 years, has been indicated.

Return Generated by Different Categories of Debt Funds in The Last 20-Years
SL Category 1-YR 3-YR 5-YR 10-YR 15-YR 20-YR
1 Overnight Fund 3.97 3.53 4.49 5.88 6 5.8
2 Liquid Fund 4.09 3.92 5.14 6.69 6.96 6.66
3 Ultra Short Duration Fund 3.95 5.79 5.02 6.27 6.28 5.98
4 Low Duration Fund
5 Money Market Fund 4 4.94 6.06 7.12 7.3 6.97
6 Short Duration Fund 3.53 6.46 6.6 7.82 8.18 7.79
7 Medium Duration Fund 1.61 5.94 6.21 7.46 8.01 7.56
8 Medium to Long Duration Fund 0.35 5.29 5.63 6.8 7.66 7.46
9 Long Duration Fund 3.33 5.67 6.47 7.72 7.79 7.67
10 Dynamic Bond Fund 0.51 6.06 4.56 6.92 7.3 6.69
11 Corporate Bond Fund 2.94 6.56 7.03 8.12 8.18 7.85
12 Credit Risk Fund 3.37 6.19 6.07 7.93 7.73
13 Banking & PSU Fund 2.66 6.04 6.63 8.25 8.02 7.58
14 Gilt Fund 3.09 6.14 6.68 9.04 7.54 7.09
15 Gilt Fund (10-Yr) 0.46 4.61 6.93 8.53 8.07 7.48
16 Floating Rate Fund 2.89 4.49 5.47 5.97 5.85 5.65

Income Tax Payable on Capital Gains

Upon selling the debt fund units for profit, the gains are subjected to income tax. The following taxes are applicable on the capital gains arising from debt funds:

  • Short-Term Gains: If the units are held for a period less than 3 years, it is deemed as short-term. Gains booked in the short term are subjected to income tax at the taxpayer’s marginal tax rate. Suppose you fall under the tax slab of 30%, then you will have to pay tax at 30%+cess on the capital gains.
  • Long-Term Gains: If the units are held for a period of more than 3 years, it is deemed as long-term. Gains booked in the short term are subjected to a flat income tax rate of 20%. Moreover, the gains are calculated after indexation. This further reduces the tax load on the investor.

The Benefits of Investing in Debt Funds

There are multiple benefits for investors arising out of debt funds:

  • Diversification: No investor can afford to ignore the need for portfolio diversification. Even the legendary investor distributes the major portion of his capital between assets and cash. Instead of cash, retail investors can park their spare money in debt mutual funds.
  • Capital Protection: In equity investing, the chances of negative returns are very high. It means, there is a high risk of invested capital erosion. Compared to equity, debt funds provide much higher capital protection security. In debt-linked investments, not only the capital is protected, but it also yields decent returns.
  • Regular Income: Senior citizens like to invest their retirement corpus to generate steady monthly income. Some debt funds issue regular dividends that can become a source of regular income.

Risks Involved With Debt Funds

We often consider debt funds as our gateway for risk-averse investing. But are debt mutual funds really risk-free? No, there are risks of loss associated with debt funds as well. Here are a few most common ones:

  • Interest Rate Risk: If we’ll see a long-term trend, the NAV of debt funds grows over time. But there is short-term volatility in the NAV due to interest rate fluctuations. Read here for repo rate vs nav.
  • Risk of Inflation: The rupee devalues with time. The devaluation is caused by the rising prices of essential and non-essential goods. This is called inflation. The net of inflation returns emanating out of debt funds can be very low or even negative.
  • Credit Risk: Most debt funds hold G-secs and Corporate bonds in their portfolio. The issuer of G-Secs is the government of India. Corporate bonds are issued by Indian companies. Credit risk is the risk of default from the issuer side. Defaults can be to return the invested capital or pay the promised interest. To negate the credit risk, mutual funds buy high-rated debt instruments.
  • Liquidity Risk: There is a risk that a particular debt fund does not have sufficient buyers. In this case, all sellers of mutual fund units may not be able to sell their holdings. Though, liquidity risks are minimal with listed securities like stocks, bonds, and mutual funds.


Debt funds are most suitable for risk-averse investors like senior citizens who wish to invest their retirement corpus for income generation. These types of funds are also suitable for equity investors who seek to make their portfolios stable. An excessive equity-heavy portfolio can be too volatile.

Debt mutual funds are of different types. Selecting a suitable scheme based on the purpose of investment is essential. For example, gilt funds are suitable for people who seek near-zero-risk capital loss. But the yield of such funds is low.

People who can take more risks can go with debt funds that invest in debt securities with longer maturity dates. Though there are interest and credit risks here sticking to high rates bonds like AA+ and above can help.

It is also essential to buy debt mutual funds whose portfolio’s average maturity time matches the investors holding time. If one’s holding time is 1 month, investing in a long-duration fund having an average maturity of 7 years will be a mistake.

For me, SEBI’s categorization of debt mutual funds works as a first guide.

I hope you liked the article.

Have a happy and safe investing.

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