What are Debt Mutual Funds? – Best Debt Mutual Funds for 2025

What are Debt Funds? –  Meaning of Debt Mutual Funds

Debt mutual funds are a type of mutual fund which invests in ‘fixed income’ securities. These fixed income securities can be issued by private, public companies and the government. Fixed income securities include:

1. Treasury Bills
2. Central/State/Municipal bonds
3. Corporate Bonds
4. Certificates of Deposits (CDs)
5. Commercial Papers (CPs)

Debt mutual funds invest in instruments having a fixed maturity period and interest payments. Hence debt funds are also known as ‘fixed income funds’ or ‘Bond’ funds. Debt funds carry lower risk than equity mutual funds. Hence their returns are also lower than equity funds. Debt mutual funds are considered to be the safest investment option in the market.

How do Debt Funds Work? – Working of Debt mutual funds

There are 2 parties to a debt mutual fund:

1. The Borrowers
2. The Lenders

The Borrowers: These are entities which need funds for growth and expansion. Borrowers can be public or private companies. Government also borrows funds for economic growth. These borrowers raise money from the market by issuing ‘Debt’. Debt is a form of loan. So, borrowers take a loan. In exchange, they promise to provide fixed interest and repay the loan on maturity. The Lenders: Lenders include retail investors, pension funds, banks etc which give money to these borrowers. Debt funds give loans to these companies. In exchange, debt fund investors get fixed interest and the principal is returned on maturity. So, basically debt funds help in shifting funds from the lenders to the borrowers.

Who Should Invest in Debt Mutual Funds?

Debt mutual funds are a perfect short-term investment option. Investors can invest for anything between 1 day to 10 years! Debt mutual funds are suitable for investors who want regular income but with low risk. Debt funds are great for senior citizens and retirees as it helps them earn higher returns than bank deposits. Even medium-high risk investors can invest in debt mutual funds to diversify their equity portfolio. Credit risk fund, a type of debt fund is perfect for high-risk investors. Credit risk funds invest in low-rated corporate bonds to earn higher profits. But these funds are extremely risky.  Debt funds are suitable for investors with various types of risk profiles: 

• Low-risk investors: Liquid Funds, Money market funds, Corporate Bonds etc. 
• Medium-risk investors: Banking & PSU Funds, Dynamic Bonds, Floating Rate Funds, Fixed Maturity Plans etc. 
• High-risk investors: Credit risk funds, long-term gilt funds etc. 

What are the Risks in Debt Funds? – Debt Mutual Fund Risks

Debt mutual funds are considered to be 100% safe. But this is not true. Debt funds do not fluctuate like equity funds, but they do carry other risks. 1. Default Risk/Credit Risk: Default risk is the biggest risk faced by debt funds in India. Default risk is when the borrowing entity fails to repay the principal or make timely interest payments. Credit risk debt funds carry highest default risk. Gilt funds carry least default risk as they invest in government securities. 2. Interest Rate Risk: Interest rate and bonds have an inverse relationship. When interest rates rise, the bond yield falls. 10-year constant gilt funds carry the highest degree of interest rate risks. Liquid funds investing in treasury bills have low interest rate risks.  3. Reinvestment Risk: Reinvestment risk is faced on bond maturity. Reinvestment risk is when you reinvest the maturity proceeds at a lower interest rate. This happens when there is a fall in interest rates.

Things to consider before investing in debt funds

1. Credit Rating of Papers: Before investing in debt funds, always check the credit rating of the underlying papers. Ideally, you should invest in debt funds with maximum exposure to AAA rated (highly safe) papers. 2. Average Maturity: This shows the average years in which the underlying papers will mature. You should match your investment horizon to the average maturity of debt funds.  3. Investment Horizon: Investment horizon is the foundation of your debt fund investment. There are different types of debt funds for different investment horizons.  Liquid funds are best for ultra short term investment horizons. Corporate bonds, Short term funds are perfect for the medium term investment horizon. Knowing your investment horizon is very critical when investing in debt funds.   4. Yield to Maturity (YTM): The YTM shows the return the fund will generate if the paper is held till maturity. The YTM keeps on changing as the fund buys and sells papers. The YTM of a debt fund helps you set your return expectation. 5. Modified Duration: Modified duration shows the sensitivity of the fund to changing interest rates. Higher the modified duration, the more volatile your debt fund will be. 6. Exit Load: Exit load helps you understand when you can redeem from the fund without any penalty. Liquid funds have an exit load of 7 days. Some credit risk funds have an exit load of 540 days! The exit load differs for each type of fund. So, before investing, match your investment horizon with the fund’s exit load period. 7. Risk – Return Ratios: You should ensure that the fund’s standard deviation is not too high. A high standard deviation means the fund is highly volatile. You should also check the fund’s Sharpe and Alpha to check its outperformance over its peers and the benchmark. 8. Expense Ratio: Expense ratio is directly related to your overall returns. Higher the expense ratio, lower your returns. Ideally, you should invest in funds with lower expense ratios. But only the expense ratio should not be your selection parameter. The fund should also be fundamentally strong.

What are the advantages of Debt Funds? – Debt Mutual Fund Advantages

1. Regular Income: Debt mutual funds invest in fixed interest instruments. Hence debt funds are able to provide regular income. 2. Superior Returns: Debt funds provide much higher returns than bank FDs. In 2020, the average return on gilt funds was 10%-12%, whereas FD returns were only 4%-5%. Debt mutual funds have also outperformed traditional investments like PPF, Endowment policies etc. 3. High Liquidity: Certain types of Debt mutual funds like liquid funds, money market funds are highly liquid. The redemption proceeds from liquid funds are received within 1 working day. 4. Higher Returns via Systematic Transfer Plans (STPs): Investors can invest in equity mutual funds through debt fund STPs. In an STP, you deposit a lump sum amount in a debt fund or liquid fund. From there, you can set up monthly transfers to equity funds. This way you can earn higher returns as you earn debt fund returns on the balance amount. 5. Tax Efficiency: The biggest advantage of debt funds over FDs is tax efficiency. In a bank FD, you pay tax every year that the interest is accrued. But in debt mutual funds, you only pay tax when you redeem the fund. Also, you get the benefit of indexation in debt mutual funds. Indexation increases your purchase price and helps you save tax. 

What are the types of Debt Funds? – Types of Debt Mutual Funds 2025

Data as of 2021

How are Debt Funds Taxed? – Debt Mutual Fund Taxation

Debt mutual fund taxation is one of the best features of debt funds. The holding period for debt funds is 36 months, or 3 years.

• If you redeem before 3 years, short term capital gains tax is applicable. The profits are added to your income and taxed as per the applicable tax slab.
• If you redeem after 3 years, long term capital gains tax is applicable. Here you get the indexation benefit. Indexation helps you increase your purchase price, which reduces your profits and tax payable.

For example: Assume you invested Rs 10 lakhs in a debt fund on 1st January 2018. On 2nd January 2021, the value of the investment is Rs 13,00,000. You have made a profit of Rs 3 Lakhs.

• If you calculate 20% on Rs 3 Lakhs, then the tax payable would be Rs 60,000.
• But with indexation, your purchase price of Rs 10 Lakhs will become Rs 11.06 Lakhs.
• Your profit will reduce from Rs 3 Lakhs to Rs 1.93 lakhs.
• Finally, your tax payable will be only Rs 38,676 not Rs 60,000!

This is how debt funds offer higher post tax returns.

Sample Debt Fund Grid – As per Risk Tolerance 2025

Data as of 2021

Sample Debt Fund Grid – As per Investment Time Horizon 2025

Data as of 2021

Debt Funds Vs. Bank Deposits & PPF 2025

Data as of 2021

List of Best Debt Funds in India - Based on Investment Horizon 2025

Data as of 2021

*This is simply the list of best debt funds. This is not an investment advice.

Final Thoughts

Debt funds are a big relief for investors looking for low-risk diversification options. But debt funds are not risk-free. Investors should prefer debt funds which invest in AAA rated papers. High-risk investors can invest in long term debt funds to earn higher returns. So, basically there is a debt fund to match all kinds of investor requirements. You can also invest in RankMF’s expert curated ‘Time Horizon’ baskets. RankMF experts have created 6 unique mutual fund baskets based on different time horizons.  There’s the ‘Best funds to invest for 1-3 months’ basket which has generated a 3 year return of 6.34%. Similarly the ‘best funds for 3-12 months’ basket has generated a 3-year return of 7.27%!  To explore these expert curated baskets, open a FREE RankMF account today!