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Debt Fund Investment Guide

Debt funds have grown in popularity as a form of investment with good returns. This is because debt funds are known to offer high returns with low risk. But how do they work, and what are the different types? What are the benefits of investing in debt funds? And what debt funds should you invest in? To help you find the answers to all these questions and more, here’s a comprehensive guide on all you need to know when it comes to investing in debt funds.

What is a Debt Fund?

Debt funds are investment instruments that have 5 features – low risk, high assured returns between 7 to 8 % (which are not dependent on the market), high liquidity (you can take your money out when you need it), low volatility (as it’s not market dependent and returns are mainly fixed), and high benefit in taxation. Unlike equity mutual funds that invest money in stocks and shares, debt funds are mutual funds that invest your money in fixed-income securities for which interest is gained.

Simply put, you can think of a debt fund as a loan that you give to a company, institute or the government on which you receive fixed interest – meaning, you make money on it.

Debt funds can help diversify an investor’s portfolio by investing in different types of assets. If one type of asset (e.g., corporate bonds) is performing poorly or has become too risky for investors to consider investing in anymore, then the investor may switch to another type (e.g., junk bonds).

This diversification helps reduce risk and increase potential returns for investors who choose to diversify their portfolio by investing in debt funds rather than holding all their investments in one particular asset class such as stocks or bonds alone.

How do Debt
Funds Work?

Debt fund investment is when you invest in debt instruments to generate income and capital appreciation. They are similar to money market funds, which invest in high-quality government securities such as treasury bills and bonds. Money market funds invest in short-term debt securities (such as treasury bills) that mature in less than one year.

Debt funds allow investors to participate in the returns of Indian corporate bonds through an easy-to-understand fund structure without managing their own portfolios. They are primarily investments in government securities and corporate bonds issued by banks, financial institutions and insurance companies. The portfolios are diversified across all bond issuers, maturities and sectors (mixed).

Benefits of Investing in Debt Funds

Independent of
Equity Market

One of the main benefits of investing in debt funds is that they are independent of the equity market. 

Debt funds do not suffer from the volatility associated with equity markets. They have historically outperformed equity funds over time, as they don’t have to deal with the same economic issues affecting equities, such as high inflation or interest rates.

Interest Rates

Debt funds can provide you with the advantage of higher interest rates. If you are looking for long-term investment and don’t want to deal with the volatility of the stock market, debt funds can be an excellent choice for you.

Debt funds are considered liquid investments that offer investors access to high-quality companies at attractive valuations. You’ll also enjoy the superior liquidity and flexibility of debt investments compared to equity investments.

Source of Income

The primary benefit of debt funds is that they provide investors with a steady stream of income while they wait for their investments to mature. The payment on the debt obligation is regularly distributed through interest payments or principal repayments.

Investors don’t have to worry about their investments going bad due to their ability to quickly exit the investment when they need cash. The returns on debt funds will always be available to investors because they can be cashed out at any time without penalty or other restrictions.

Lower Risk

Debt funds are considered low-risk investments because reliable borrowers back them with strong credit profiles. Debt funds also have lower risk than other equities as they do not depend on the earnings of specific companies.          

The risk of default is minimal since these funds are guaranteed by government agencies such as the RBI. Debt funds are an excellent choice if you’re looking for a place to put your money where it will be safe.


Diversification is another crucial benefit investors can enjoy when they invest in debt funds. The idea behind this advantage is that you can reduce your overall risk by investing in a wide range of assets. Basically, it ensures that you have more options when making investment decisions, thus reducing your overall risk level.

Debt funds have different types of assets like government securities, corporate bonds, securitised products and other financial instruments. This ensures that the investor does not put all his eggs in one basket.


Debt funds are tax-efficient because you don’t have to worry about capital gains taxes when you sell your investments. Because the profit from these types of investments is taxed at lower rates, investors who hold them for a longer period of time can put more money into their retirement accounts without incurring a higher tax bill than they would have if they were just investing in regular stocks or bonds.

This can help you save more for retirement than if you were just investing in stocks or bonds directly because you won’t have to pay taxes on that income until it’s time to withdraw it from your account.

Hedge Against Volatility

Debt funds are an excellent way to hedge against volatility, as they are designed to provide stable returns with the possibility of capital appreciation. They help you build your financial assets over time so you can meet your goals, even during periods when the markets may be volatile.
Hedge against volatility is a strategy that aims to reduce the downside potential of an investment portfolio by using derivatives or other financial instruments. It is most commonly used by traders who want to reduce their risk on a portfolio.

Who Should Invest in a Debt Fund?

A debt fund is an excellent option to help investors meet their short-term financial goals or emergency needs.

It is also a good option if you want a reliable fixed source of income.

Types of Debt Funds

1. Liquid Funds


Liquid Funds

Liquid funds invest in different types of securities like municipal bonds, corporate bonds and government securities. These types of debt instruments are considered risk-free investments because they are backed by government authorities or well-established companies like banks or financial institutions. Liquid funds invest in these securities by getting them through primary market transactions through public sales or secondary market transactions through private placements.

The main difference between liquid funds and other debt funds is that they are not restricted to one type of debt or another. They can also invest in both fixed-income investments as well as equities. Liquid funds have lower risk than other debt funds because they tend to hold liquid assets such as short-term government securities.

2. Short & Ultra-short-term Funds


Short & Ultra-short-term Funds

Short & ultra-short-term debt funds are debt funds that seek to provide a return over a short period of time. These are the two most popular types of debt funds, and they have different objectives.

Short-term debt funds aim to buy low and sell high, while ultra-short-term debt funds aim to sell their investments as soon as possible in order to minimise risks and maximise profits. Short-term debt funds can be used for short-term purposes and other financial goals.

Ultra-short-term debt funds also offer higher returns than traditional short-term investment funds. While there is no guarantee that investors will profit from investing in ultra-short-term debt funds, they have some advantages over traditional short-term investment funds due to their ability to generate profits more rapidly than conventional investments.

3. Money Market Funds


Money Market Funds

Money market debt funds, or money market funds as they are also known, offer investors access to short-term debt instruments. These investment products have a very low-interest rate, typically below 4% per annum.

The main benefit of investing in a money market fund is its low fees and charges. This makes them suitable for individuals who want to invest their savings and are not interested in the long-term benefits of an equity investment.

Investors can buy units through an online broker or a stockbroker, who then holds the assets on their behalf until maturity. The unit's value will increase with the economy's growth and the issuer's performance.

4. Dynamic Bond Funds


Dynamic Bond Funds

As the name suggests, dynamic bond funds are the funds in which your fund manager keeps changing your portfolio based on the fluctuating interest rate. Dynamic bond funds can have different maturity periods because they usually invest in instruments of both longer and shorter maturity periods.

5. Corporate Bond Funds


Corporate Bond Funds

Corporate bond funds are one of the most popular investment options for investors who want to gain exposure to bonds. Corporate bond funds invest in bonds issued by companies with stable valuations and strong credit profiles. These funds allow you to invest in high-quality corporate bonds, providing better returns than stocks.

Corporate bonds, or fixed-income securities, are debt instruments that provide investors with a regular cash flow and are backed by the company issuing them. They can be highly liquid and offer a low risk of default like short-term paper. The interest rates on corporate bonds tend to be lower than those on other types of assets such as bank deposits or money market funds.

Corporate bond funds typically invest in a diversified portfolio of high-quality corporate bonds from different issuers. They will typically have an average duration of three years, meaning there is enough time between each coupon payment to allow the fund manager to reinvest at least some of its proceeds into other securities to increase returns over time while also minimising risk exposure through diversification.

6. Credit Risk Funds


Credit Risk Funds

Credit risk funds are designed to take on higher levels of risk than other types of funds. The goal is to maximise your return while minimising the amount of credit you need to invest. These funds invest in debt securities of companies with a lower credit rating. Credit risk funds invest in subprime and leveraged loans, which are secured by collateral such as real estate, vehicles and other assets. These loans are more likely to default than companies with better ratings.

The main advantage of investing in credit risk funds is that it provides diversification benefits over standard bond funds. It also offers the opportunity to earn higher returns than fixed-income investments such as bank deposits and cash reserves.

7. Banking and PSU Fund


Banking and PSU Fund

Banks and public sector undertakings (PSUs) are the two most important types of investment funds. Banking debt funds invest primarily in medium-term time deposits with banks. Time deposit refers to money deposited for a specific period of time at a fixed interest rate that does not change after it has been deposited. This means that even if interest rates go down, your money will still earn the same interest rate until the maturity date of your deposit note.

On the other hand, PSU bond funds invest primarily in short-term notes issued by the government or public sector enterprises (PSEs). Both types of debt funds have their benefits but may not be suitable for everyone.

8. GILT Funds


GILT Funds

Gilt funds are a type of debt fund that invest in gilts or bonds issued by the government. Gilt funds typically invest in various gilt issues and can be used to help diversify an investment portfolio. They have the advantage of being relatively low risk and are suitable for those with a limited appetite for risk but still want to participate in the equity markets.

Gilt funds are generally very liquid funds with regular reviews and trade throughout the day on a secondary market. They can also be bought and sold directly from your broker's website.

Gilt funds are usually considered appropriate for investors with moderate risk tolerance and various bonds available to suit your requirements.

9. Floating Rate Funds


Floating Rate Funds

Floating rate funds have a floating rate of interest. This means that the interest paid by the fund is never fixed. Instead, it changes according to market conditions and other factors. Floating rate funds are popular because they offer the flexibility to invest in a wide range of investments without any restrictions on their interest rate.

The main benefit of floating rate funds is that you can use them for short-term investment purposes. This means you can use them for saving, investing in your retirement accounts, or even emergency funds.

10. Fixed Maturity Funds


Fixed Maturity Funds

A fixed-maturity plan is a type of debt fund that invests in a single company. Unlike a regular debt fund, the investor is promised to receive a specific amount of money at some point in the future. The fixed-maturity plan has one objective, which is to be repaid by one entity.

For example, if you invest in a debt fund with a fixed maturity date, you will receive your principal (or interest) at the time of maturity. Therefore, you don't have to worry about losing any money if the company goes bankrupt as long as you pay back your principal at maturity.

The disadvantage of this type of investment is that it does not give you any options for investing or diversifying your portfolio. Therefore, if no dividends are coming from the company, then the value of your investment will only go down when interest rates rise or when inflation increases.

Things to Consider Before Investing in Debt Funds

Debt funds are a good investment if you have a cash surplus, but there are some things to consider before investing in debt funds. Many factors can affect the value of a debt instrument and its interest rate.

The riskiest debt instruments tend to be government bonds, which often have negative real yields (the return on an investment minus inflation). However, there are a number of other risks that investors take when investing in debt funds:


Credit Risk

If the issuer of a debt instrument goes bankrupt, creditors will face losses. This risk is exceptionally high if the issuer has been issued bonds by governments, who often have less financial stability than private companies or companies in other sectors such as utilities or telecoms.



If a company fails to repay its debts, its bondholders may lose all or part of their investments. However, some issuers have limited recourse against their bondholders in the event of bankruptcy if they don’t meet certain minimum requirements, such as having sufficient cash reserves and being able to pay interest on time.


Trading Costs

Debt funds charge trading costs that can be costly if you don’t have a good exit strategy at hand when the time comes to sell your shares or redeem your fund shares. To avoid these costs, you need to implement a systematic exit strategy before redemption begins so that you can get back what you invested and then some more.


Which debt fund is the best?

There is nothing such as the best debt fund because choosing the right debt fund depends on your investment period. People who want to invest for a single day to a month can go for liquid funds or overnight funds. At the same time, people who want to go for a six-month investment can choose ultra-short-duration funds. In addition, money market funds are suitable for those who invest for six months to 1 year. Lastly, if someone is thinking of a long-term investment, you can go for banking & PSU bond funds and corporate bond funds.

Which debt funds are safe?

Liquid funds and overnight debt funds are considered to be the safest among all the debt funds available today. Since both of these debt funds have the lowest maturity days, the interest rate risk and credit risk that these funds can take get significantly reduced.

Is it good to invest in debt funds?

Investing in debt funds is an excellent investment, especially when you want to fulfil your near-term goals and earn returns on your capital.

How do I choose a debt fund?

The first step to choosing a debt fund is determining your investment period. Once you have decided on your investment period, select a debt fund category and choose a debt fund from your selected category. That's it - make sure you go for a fund that lends to good companies and fits your duration criteria.

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