What is Debt Fund - Meaning, Types, Returns, Risk, How to Select Best Debt Fund

Manish Kothari
20 Likes | 825 days ago



isVerifiedExpertAuthor is a Zfunds Verified Expert
Manish Kothari


Debt funds are mutual funds that are generally a mixture of fixed income or debt securities like Treasury Bills, Government Securities, Corporate Bonds, other debt securities, and money market instruments of different maturities. These funds invest in bonds that are assigned credit ratings which show the capability of the issuer to pay back the debt over a given period. These ratings are issued by firms like CARE, CRISIL, ICRA, and FITCH. These funds can be differentiated based on the instrument they choose to invest in. For instance, if the maturity period of the underlying instruments is shorter than a year, then such instruments are called treasury bills or commercial paper. However, if the maturity period is longer than one year, they are called debentures or bonds.

The issuer of these securities is legally bound to pay the principal along with interest at the end of the agreed-upon period. Also, there can be periodic coupon payouts (interest) as per the debt agreement. Generally, an investor in debt securities is concerned about the face value, interest rate, period, and maturity value of the papers. On average, the underlying securities in debt funds are held until maturity, unlike equity mutual funds that see a lot of enfeebling.


  1. Liquid Funds

Liquid funds predominantly invest in debt instruments with a maturity period not exceeding 91 days, hence providing high liquidity. Such instruments generally include commercial paper, treasury bills, collateralized lending & borrowing obligations, and certificate of deposits. These funds might prove to be an attractive alternative to individuals and corporations as a means to park their idle funds for a short duration, which could be as low as a day.

2. Ultra-short-term funds

These funds invest in debt instruments such that the average maturity period of the portfolio is between 3 months to 6 months. They invest in a range of debt and money market instruments and are ideal for investors looking to park their idle funds and cash management or where the investment horizon is short term.

3. Low Duration Funds

These invest in money market and debt instruments such that the maturity duration of the portfolio falls between 6 to 12 months

4. Short Term Debt Funds

These funds invest in government and corporate bonds with a Macaulay duration ranging between 1 to 3 years. These funds are best suited for customers that have a low or medium risk appetite.

5. Money Market Funds

These funds invest in the Money Market instruments with a maturity period up to 1 year. 

6. Medium Duration Funds

These invest in medium-term government securities and company bonds with a maturity mix aligned as per the interest rate outlook. The duration of the portfolio generally falls between 3-4 years. Portfolio duration under an adverse situation can be from 1 to 4 years. These funds are ideal for customers that are looking to benefit from falling interest rates or higher yields.

7. Corporate Bond Funds

These predominantly invest in AA+ rated corporate bonds and above with an 80% minimum exposure in corporate bonds with high credit ratings. The average maturity of these funds could vary from one fund to another.

8. Credit Risk Funds

These invest in AA and below rated corporate bonds and with a minimum 65% exposure in such securities. Due to underlying low rated securities, these funds generally offer higher YTMs returns. However, these funds are generally highly risky and an investor should perform a complete due diligence prior to investing in such a fund.

9. Banking and PSU Fund

These predominantly invest in debt instruments of PSUs (Public Sector Undertakings), Public Financial Institutions, Banks, and Municipal Bonds. The minimum investment in such instruments should be 80% of total assets.

10. GILT Funds

The primary objective of this fund is to generate credit risk-free returns through investments in sovereign securities issued by the Government of India or State Governments. The minimum investment in Govt securities should be 80% of total assets. (across maturity)

11. Fixed Maturity Plan:

These are closed-ended debt funds that generate income through investment in the money market and debt instruments as well as government securities maturing on or before the maturity date of the plan. These are ideal for customers looking for accrual of income with minimal duration risks.

12. Floating Rate Funds:

These predominantly invest in floating rate debt securities. This fund can also be termed as variants of income funds that minimize the volatility risk. The minimum investment in floating rate instruments is 65% of total assets.

13. Long Duration Funds

Long Duration Funds are managed actively to generate constant and steady returns over different market scenarios. These funds invest mostly in long-term securities comprising Debentures, bonds, and Government securities(G-sec). The duration of these funds are generally more than 7 years.

14. Dynamic Bond Fund

Dynamic Bond funds invest dynamically in debt instruments including short & long-term debt securities depending upon the market conditions. They aim to make investments while predicting the interest rate movements in the market so as to benefit from short term fluctuations in bond values.

They are ideal for investors with moderate risk appetite who are looking to invest for a period of 3 to 5 years.

15. Overnight Funds

Overnight funds invest in securities with a maturity of one day. Given the very short duration of investment, they are generally not affected by interest rate movements in the market. As investments are made in high-quality securities with overnight maturity the chances of defaults in these funds are almost negligible. They are often considered as safe investments.

16. Medium to Long Duration Fund

Medium to Long Duration funds are open-ended debt schemes that invest in debt securities & money market instruments with a duration between 4 to 7 years.

17. Gilt funds with 10 yr constant return

It is similar to the Gilt fund as discussed above, but as the name suggests the investment of this fund is done in government securities with a maturity of 10 years.


Below heads should be considered before choosing the right fund:

  1. Investment Objective:

Do you need returns early or in the long term? For how long do you want to invest? The answer to these queries will help one pick the right fund.

2. Risk

Though debt funds are less volatile than equity funds, they have risks related to interest rates and credit risk. One should be well informed of the associated risk before choosing the debt fund. 

3. Returns:

Though debt funds are well known for being fixed income securities, there is no guarantee of return. It depends on the overall rate of return prevailing in the economy. Therefore, one should be aware of the factors affecting returns on the investment.

4. Investment Tenure:

One should choose a fund keeping in mind the time period i.e. tenure which one wishes to invest in. Accordingly, it can be ultra-short, short, long term, etc. Generally, for the long run, higher returns can be expected.

5. Category of fund:

As per one's investment tenure and requirements, there are different categories of funds such as fixed maturity plans, short-term debt funds, medium term funds & credit risk funds among others as discussed above. The one which is most relevant and feasible to one's needs & requirements should be picked up. 


1. Diversification:

Investing a certain portion of funds in debt funds shields one's portfolio from the volatility of equity investments.

2. Managing risk:

Investing in debt funds reduces the overall risk of losses in the portfolio and these are comparatively less volatile than equity-based funds.

3. Regular Income

Debt mutual funds can be a good source of income especially for investors who need regular & steady income to meet their financial requirements. Investors can make investments in their selected debt funds & later can use the SWP (Systematic Withdrawal Plan) to have regular income at periodic intervals from the fund.  

4. Opportunity to invest in debt instruments:

Debt funds provide retail investors with an opportunity to invest their funds in various debt instruments such as Bonds, Government Securities, Non-Convertible Debentures among others that retail investors otherwise cannot participate in because of high minimum investment limits. 

5. Opportunity to part short-term surplus:

Unlike equity-based funds that are generally very volatile within the short run, some debt funds provide an opportunity for retail investors to park their surplus for a brief while and earn decent returns thereon.

How do Debt Funds work?

Debt funds invest their assets in the debt instruments like government securities, corporate bonds, money market instruments etc. Debt instruments have a fixed rate of return associated with them along with a fixed maturity. Debt funds pool the money from different investors and then allocate the pooled money in different debt instruments based on their investment objective. The return which the debt funds earn from their investment is further distributed to the investor of the funds in the proportion of the investment.

After the maturity of the securities, the fund gets back the principal amount. And, then again that principal amount is invested in different securities to generate a return. This cycle is repeated every time and this is how the debt funds work.

Expense Ratio in Debt Funds

The fund management fees which are charged by the funds is known as the expense ratio. The expense ratio includes the fees for the fund manager, administration cost, and some other costs and fees. As per the SEBI guidelines, the expense ratio for the funds cannot be more than 2.25% of the total assets. The expense ratio is deducted from the total AUM at the end of the specified period. The expense ratio is deducted from the AUM irrespective of the positive or negative return from the fund.


Debt funds are most suited for investors having a low to moderate risk appetite. The risks of investing in debt funds are lower than equity base funds. For investors interested in low to moderate risk investment products, these funds can be a good choice. One can also choose debt funds to park their surplus funds. 

Another reason to invest in these funds is to achieve diversification in the investment portfolio. This can be a good way to reduce the overall portfolio risk in case one has a higher equity allocation. The debt component can help to cushion the volatility of the equity market. 


Debt funds offer a lower rate of return when compared to equity-based funds. The returns from debt mutual funds depend upon factors like the portfolio’s YTM, duration, maturity & others. So, the returns from debt funds vary across different categories & schemes within the categories based on their portfolio.

These schemes are suitable for investors who are looking for investments with low to moderate risk profiles offering more stable returns. 


Investing in debt funds carries different types of risk. These risks include interest rate risk, credit risk, inflation risk, reinvestment risk, etc. But the key risks which need to be taken into consideration while investing in a Debt fund are Interest rate risk and Credit risk.

1. Interest Rate Risk: The interest rate and market price of the bond carries an inverse relationship. Whenever interest rates in the market fall, the market prices of the bond goes up and vice-versa. The effect is more on bonds with longer maturities vis-a-vis instruments with shorter maturities. This causes fluctuations in the NAV of debt mutual funds.

2.  Credit RIsk: Credit risk or default risk is the chance that a borrower might not repay the principal or interest  payments on the committed dates. This risk can be determined by “Credit Ratings” given on these funds by agencies like ICRA, CRISIL, CARE, etc. which rate the issuer of the bond and their ability to repay by analyzing and assessing their overall financial position.


Investments in debt mutual funds have the following taxability:

  • If the units of the scheme are held for a period of up to 3 years, then the capital gains earned are referred to as short-term capital gains i.e STCG. STCG is added to one’s taxable income and taxed as per the applicable income tax slab.
  • If the units are held for more than 3 years, then the capital gain is referred to as long-term capital gain i.e. LTCG. LTCG is taxed at 20% along with indexation benefits.


  • One can generally invest in a debt fund through two methods:

SIP i.e. Systematic Investment Plan: If one wants to invest smaller portions of funds at regular intervals, a SIP can be a suitable alternative. This is better matched for salaried individuals. Investing through the SIP route enhances investment discipline while reducing the risk through rupee cost averaging which helps to buy more units when prices are low and vice versa.

Lump-Sum Investments: In case one has a considerable amount of funds and wishes to invest in one go, the lump sum method is ideal. If one gets a significant corpus of funds, this is an apt option. However, the investment horizon or your goal should be kept in mind while choosing the fund type.

How to Invest?

Just like every other investment decision, before signing the dotted line, you must properly determine your financial goals, risk tolerance, and investment horizon.

You can easily start investing in mutual funds through the ZFunds App available on the Google Play Store.


  • Download the ZFunds App from Play Store.
  • Select the “New User” option after opening the app, and enter your “Full Name” & “Mobile Number”. Click “Submit”.
  • ZFunds homepage will be displayed on your screen showing different types of mutual funds & their categories.
  • Select the “Please complete your profile” option appearing at the top of your screen. There, you would have to complete the KYC process if you haven’t done it already.
  • Enter your “PAN Card Number” & “Date of Birth” to check the KYC Status, if it is done already then you don’t need to do it again.
  • If KYC not registered, then you will be redirected to a page for filling KYC Information.
  • After that, You will be asked to enter information like your Name, Gender, Marital Status, Father’s Name, Mother’s Name, Income Range, Mobile Number, Occupation, and other demographic details. Also, you will have to enter your Address(As per ID proof) along with Pincode.
  • After filling in the information, you have to upload the following pictures :
  • Your Signature (as on PAN Card)
  • Adhaar Card or any other ID proof.

            Then Click Next.

  • After that, you will need to enter your Bank account details i.e Your Bank Account no., Bank IFSC Code & MICR Code.
  • Tick the “I want to add a nominee” option if you want to add a nominee. Otherwise, leave it blank.
  • Then click “Finish”.
  • After that, you can choose from different mutual fund schemes to invest as per your needs & requirements.

You will receive a confirmation message & a mail, once all your documents are verified & KYC gets approved (For Non-KYC registered users). Also, you will receive confirmation regarding your investments in mutual fund schemes along with the status of the allotment of units.

Frequently Asked Questions

  • What are debt funds?

The mutual funds which invest the pooled money from different investors in debt instruments are called debt funds. These funds allocate their assets in different debt instruments like corporate bonds, government securities, T-bills, debentures, etc. The allocation and investment in different debt securities is made on the basis of the investment objective of the fund.

  • What are the different types of debt instruments?

There are many different types of debt instruments. Some of them are mentioned below:

  1. Government bonds
  2. Treasury bills
  3. Commercial papers
  4. Corporate bonds
  5. Government securities
  • What are the different categories of debt funds?

There are 16 different types of debt mutual funds. Some of them are:

  1. Corporate bond funds
  2. Money market funds
  3. Overnight funds
  4. Banking & PSU funds
  5. Gilt funds
  6. Long duration funds
  • Which type of risk is involved in the debt funds?

Debt funds have some risk involved with them. Some of the risks involved in debt funds includes:

  1. Credit risk
  2. Interest rate risk
  3. Reinvestment risk
  • How are debt funds taxed?

Debt funds are taxed with capital gain tax under the Income Tax Act,1961. Capital gains tax is taxed as a short-term capital gain (STCG) and long-term capital gain (LTCG). 

When the units are redeemed within 36 months from the date of the investment, the gains are taxed as STCG. The gains are added to the income and are taxed as per the income tax slab rate of the investor and when the units are redeemed after 36 months from the date of the investment, the gains are taxed as LTCG. LTCG is taxed at the rate of 20% after the benefit of indexation.

More Information:

What is Expense Ratio in Mutual Funds
How to Invest in Mutual Funds in India?
Important Tips for Mutual Fund Investment
Tax Saving Options under Section 80C
How to Become Mutual Fund Advisor?
ARN Code - Purpose, Registration, Renewal, How to Apply Online
Nism VA Certification: Objective, Preparation Tips, Fees, Exam Certificate
Mutual Fund Distributor Commission Structure
EUIN Number: Purpose, Registration, Rules, Renewal Process

Get Investment Advice from India's Top Experts