There are various types of debt mutual funds that suit the requirement of different investors’ risk profiles and investment objectives.
- Overnight fund
- Liquid Mutual Fund
- Ultra-Short Duration Mutual Fund
- Low Duration Mutual Fund
- Money Market Mutual Fund
- Short Duration Mutual Fund
- Medium Duration Mutual Fund
- Corporate Bond Mutual Fund
- Credit Risk Mutual Fund
- Banking & PSU Mutual Fund
- Dynamic Bond Mutual Fund
- Gilt Mutual Funds
This article covers:
- What is Debt Fund with example
- Types Of Debt Funds
- How To Choose Debt Funds
- Debt Fund Taxation
- Best Type Of Debt Funds
- Types Of Debt Mutual Funds- Quick Summary
- Types Of Debt Mutual Funds- Frequently Asked Questions
What is Debt Fund with Example?
Debt mutual funds are a type of mutual fund that allocates money in various debt instruments or fixed-income assets such as corporate bonds, government securities, treasury bills, commercial papers, and many other debt instruments. It is also known as bond funds or income funds,
The tenure of debt fund instruments is fixed, and the investors earn interest until maturity. They provide better returns than conventional investments such as fixed deposits and are comparatively less unstable than equity mutual funds.
For example, a debt fund may invest in government bonds issued by the Indian government, corporate bonds issued by companies such as Reliance or Tata, or money market instruments such as commercial papers and certificates of deposit. The fund manager will allocate the fund’s assets across these different securities based on their credit quality, duration, and yield.
Types Of Debt Funds
Liquid Mutual Fund
A liquid mutual fund invests in short-term debt securities such as certificates of deposit, treasury bills, and commercial papers with a maturity period of up to 91 days. These funds are designed to offer a high level of liquidity, making them ideal for individuals who seek to park their money for a short duration.
One of the primary advantages of investing in liquid mutual funds is that they provide higher returns than traditional savings accounts, with relatively lower risk. Furthermore, they offer easy accessibility as investors can liquidate their investments in just seven days without paying any penalty.
Overnight Mutual Fund
Overnight mutual funds are the type of debt funds that provide loans to companies or businesses for 1 working day. These funds lend money to regulated corporations, including banks, insurance companies, mutual funds, provident funds, and NBFCs, and provide investors with a low-risk investment option. They invest in cash and cash equivalents such as CBLOs and overnight reverse repos that mature in one day.
Ultra-Short Duration Mutual Fund
Ultra-Short Duration Mutual Fund is a type of fund that gives loans to companies for 3 to 6 months. The maturity period of this fund is less than a year. It is ideal for those who have idle surplus cash and want to generate better returns than FD or savings accounts. They give a somewhat greater yield than liquid funds. These funds provide low-risk investment options and can be considered as an alternative to fixed deposits.
Low Duration Mutual Fund
Low Duration Mutual Funds are debt funds that invest in short-term debt securities with a duration of 6-12 months. They are relatively safer than equity instruments and offer higher returns than bank fixed deposits of comparable tenure. Low-duration funds use strategies based on credit risk and interest rate risk to generate returns, earning through interest income and capital gains. These funds are suitable for investors with at least a 3-month investment horizon who want regular income or an alternative to bank deposits.
Money Market Mutual Fund
Money Market Mutual Funds are a type of debt mutual fund that invests in low-risk, short-term fixed, income securities such as commercial paper, certificates of deposit, and treasury bills. These funds are designed to provide a high level of liquidity and stability to investors with a short-term investment horizon ranging from a few months to one year. They offer relatively low returns but are considered to be safe investments with minimal risk of loss.
Money Market Mutual Funds are an excellent option for investors who want to park their money for a short duration and earn returns that are higher than traditional savings accounts or bank fixed deposits.
Short Duration Mutual Fund
Short Duration Mutual Funds are investment vehicles that focus on debt securities with shorter maturities between one to three years. These funds are designed for investors who seek a balance between yield and capital preservation while minimizing interest rate risk. Short-duration funds tend to offer higher yields than money market funds, making them a suitable alternative for investors looking to generate income from their investments.
These funds also have lower volatility compared to longer-duration funds, which makes them a relatively safe option for investors.
Medium Duration Mutual Fund
Medium Duration Mutual Funds are debt funds that invest in high-quality corporate bonds and lend to quality companies for 3 or more years. These funds are suitable for investors who have an investment horizon of at least 3 years and are looking for stable returns that are relatively less volatile than equity investments. One of the significant advantages of Medium Duration Funds is that they can be a worthy replacement for medium-to-long term Fixed Deposits.
Corporate Bond Mutual Fund
Corporate Bond Mutual Funds invest at least 80% of their corpus in corporate bonds with the highest possible credit rating. These funds are ideal for investors with a moderate risk appetite and want to earn better returns than traditional fixed deposits. One of the major advantages of investing in Corporate Bond Mutual Funds is that they offer higher returns than bank fixed deposits with similar investment horizons. Additionally, these funds are suitable for investors who have a time horizon of 2-3 years or longer.
Credit Risk Mutual Fund
Credit risk funds are a type of debt fund that lends most of its money to companies with lower credit ratings. The higher interest charged to such companies compensates for the risk taken by the lender due to an increased possibility of default. While these funds are usually short-term, they are considered to be one of the riskiest options in the category.
Credit risk funds may be suitable for investors with a long-term investment horizon of at least 3-5 years. However, there is a high probability of incurring a loss in the short term due to the risky nature of these funds.
Banking & PSU Mutual Fund
Banking and PSU Mutual Funds are debt funds that primarily invest in debt instruments issued by banks and public sector undertakings (PSUs). These funds are considered to be relatively low-risk investments as the borrowers have a strong financial standing and are usually backed by the government.
These funds provide stable returns but are also subject to interest rate risks. These funds are a good option for investors with minimal risk and have an investment horizon of a minimum of 2 to 3 years.
Dynamic Bond Mutual Fund
Dynamic bond funds are an ideal option for investors who want to capitalize on interest rate movements in the economy. However, the performance of these funds is highly dependent on the fund manager’s ability to accurately predict the direction of interest rates.
Dynamic bond funds tend to generate higher returns than other debt funds but also carry higher risk. It is recommended that investors should have a minimum investment horizon of 3-5 years to benefit from investing in dynamic bond funds.
Gilt Mutual Funds
Gilt mutual funds put money into government securities. The maturity period can range from 3 to 5 years. Gilt mutual funds are suitable for those who do not want to take risks as they do not bear credit risk. However, they do carry interest rate risk. People generally tend to move their money towards gilt funds when the interest rate is falling.
How To Choose Debt Funds
Here are the steps you can follow to choose the best debt fund for your portfolio:
- Determine your investment horizon and risk appetite: Before choosing a debt fund, it is important to understand your investment goals, risk tolerance, and when you will need the funds. This will help you decide on the duration of your investment, your return expectations, and your risk profile.
- Know the different types of debt funds: Debt funds are categorized based on their investment tenure and the nature of the bonds they invest in. Knowing the different types of debt funds available will help you choose a fund that matches your investment horizon and risk appetite.
- Beware of risks involved: There are two main risks involved in investing in debt funds – interest rate risk and credit risk. Interest rate risk is the risk of fluctuations in the interest rate, while credit risk is the risk that the fund may not pay on time.
- Diversify: Diversification is important for any investment portfolio. Allocate your investments across different types of debt funds, as well as equities, to minimize risk and maximize returns.
Debt Fund Taxation
Long-term capital gains: When you sell units of a debt fund after three years, the capital gains earned on the investments are called LTCG (long-term capital gains). From April 1, 2024, the LTCG earnings from the debt mutual funds are taxed according to the investor’s income tax slabs in which their total income is falling. There are no indexation benefits provided to the investors on the LTCG taxation.
However, if you have invested in the debt funds before the 1st of April 2024, the LTCG taxation rules are the same, and these gains are taxed at a flat rate of 20% after indexation. Indexation is a process by which the cost of acquisition of the asset is adjusted for inflation. This adjustment is made using the Cost Inflation Index (CII), which is published by the government of India every year. By adjusting the cost of acquisition for inflation, indexation helps to reduce the tax liability of the investor. Also, the tax on long-term capital gains, you may also be levied with applicable cess and surcharge on tax. The surcharge and cess rates vary depending on the investor’s income level and the type of investment.
Short-term capital gains: When you sell units of a debt fund within three years, the gains earned on the funds are called short-term capital gains and these gains will be taxed as per the income tax slab rate that the investor falls under.
Best Type Of Debt Funds
The best type of debt funds are given below:
| Name of the debt fund | Returns per annum | Expense ratio |
| Aditya Birla Sun Life Medium Term Direct Plan-Growth | 21.8% | 0.81% |
| UTI Banking & PSU Debt Fund Direct-Growth | 10.5% | 0.24% |
| ICICI Prudential Short Term Fund | 6.26 | 0.39% |
| UTI Bond Fund Direct-Growth | 11.56% | 1.29% |
| Nippon India Ultra Short Duration Fund | 5.76% | 0.38% |
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Types Of Debt Mutual Funds- Quick Summary
- There are different types of debt mutual funds, including liquid funds, ultra-short duration funds, low duration funds, money market funds, short duration funds, medium duration funds, corporate bond funds, credit risk funds, banking & PSU funds, dynamic bond funds, and gilt funds.
- Debt mutual funds invest your money in different companies’ bonds, government bonds, etc. Basically, the fund manager of the mutual fund gives your money as a loan in the market and shares the returns with you.
- Debt funds should always be a part of your portfolio because limiting your investment options to just the stock market makes your portfolio a little risky. Also, Debt funds are less volatile. Hence, Investing in debt funds helps you to diversify your portfolio to minimize the risk.
- When choosing debt mutual funds, make sure to do proper research about the type of funds and the past returns.
- Debt mutual funds have different tax implications, depending on the type of fund and the investor’s holding period.
- The best type of debt funds are Aditya Birla Sun Life Medium Term Direct Plan-Growth, UTI Banking & PSU Debt Fund Direct-Growth, and ICICI Prudential Short Term Fund.
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Types Of Debt Mutual Funds- Frequently Asked Questions
1. What are different types of debt funds?
The different types of debt funds are Money Market Fund, Dynamic Bond Fund, Corporate Bond Fund, Banking and PSU Fund, Gilt Fund, Credit Risk Fund, Floater Fund, Overnight Fund, Ultra- Short Duration Fund, Low Duration Fund, Short Duration Fund, Medium Duration Fund, Medium to Long Duration Fund, Long-Duration Fund.
2. Which type of debt fund is best?
It is not possible to say which type of debt fund is best as it depends on various factors such as the investor’s investment objective, risk tolerance, and investment horizon. For example, if an investor has a short-term investment horizon, then a liquid fund or an ultra-short-duration fund may be suitable.
3. Which type of debt fund is safest?
Generally, short-term debt funds and overnight funds are considered to be relatively safer than long-term debt funds or credit risk funds.
4. Which debt fund is better than FD?
- Aditya Birla Sun Life Medium Term Fund: 8.6 %
- ICICI Prudential Long-Term Plan: 8.0 %
- Franklin India Ultra Short Bond Fund: 9.0 %
- Axis Income Fund: 8.0 %
5. Is debt fund tax-free?
Debt funds are not tax-free, and their taxation depends on the holding period of the investment.
6. Which debt fund gives the highest return?
Aditya Birla Sun Life Medium Term Direct Plan-Growth gives the highest return which is 21.8%.
7. Is there TDS on debt funds?
No, there is no TDS on debt funds. However, the capital gains earned on debt funds are taxed based on the holding period.
8. Are debt funds profitable?
Debt funds offer an average return of 10 to 12% annually. They have the potential to offer higher returns than traditional fixed deposits and savings accounts.
