Types of Debt Funds in Mutual Funds Explained

For Indian investors looking for stability, regular income, and lower volatility than equity, debt funds have become a popular choice. Yet, many new investors may not know about the types of debt funds, how they work, and which category of debt funds will best suit their financial goals. Such confusion usually results in a bad investment decision or too high return expectations.

This blog explains the types of debt funds, what they mean, their categories, risk levels, and expected returns.

What Are Debt Mutual Funds?

Starting with the debt mutual funds meaning, these are typically funds that invest in fixed income instruments, including government securities, treasury bills, corporate bonds, deposit certificates (CDs), and commercial papers. The goal is to protect and grow investment capital with regular cash flow.

They are also called debt-oriented mutual funds since not less than 65% of the net assets are invested in debt and money market instruments. Unlike equity funds, the returns here are a byproduct of interest rate shifts and credit quality, rather than company growth.

When investors read about debt mutual funds, they normally realise that these schemes are more predictable than equities but not risk-free.

Why Understanding the Types of Debt Funds Matters

Understanding the types of debt funds helps investors:

• Match investments with time horizons
• The ability to manage interest rate and credit risk.
• Plan short-term and long-term goals
• Avoid unnecessary volatility

India’s mutual fund ecosystem offers several debt mutual fund types, each designed for a specific investment duration and risk appetite.

Classification of Debt Funds Based on Investment Horizon

One of the simplest ways to understand the types of debt fund is by classifying them according to investment duration.

1. Short-Term Debt Funds

These cash funds invest in 1- to 12-month securities. They are also good to park your extra money.

2. Medium-Term Debt Funds

They tend to invest in instruments with maturities in the 3-to-5-year range, offering a compromise between risk and return.

3. Long-Term Debt Funds

Long-duration funds invest in securities with maturities beyond five years and are sensitive to interest rate changes.

This horizon-based grouping explains why different debt mutual fund types behave differently during interest rate cycles.

Types of Debt Funds Based on Portfolio Composition

Another good way to categorise the types of debt funds is based on what they invest in.

1. Government Securities (Gilt) Funds

These invest in only government-backed securities and are free from credit risk, but are subject to interest rate risks.

2. Corporate Bond Funds

They mostly invest in top-rated corporate bonds and give a bit more yield than government securities.

3. Credit Risk Funds

These funds buy less creditworthy bonds to generate higher returns, but they come with more credit risk.

This classification helps investors differentiate among various debt mutual fund types based on portfolio quality.

Major Types of Debt Funds in Mutual Funds (SEBI Classification)

Below is a comprehensive table explaining the most common types of debt funds available to Indian investors.

Comparison Table: Types of Debt Funds

This table simplifies the understanding of types of debt funds in mutual funds without recommending any specific scheme.

Duration Risk Explained Simply

Duration risk refers to how sensitive a debt fund is to changes in interest rates.

• Short-duration funds are less affected by rate changes
• Long-duration funds react sharply to rate movements

Hence, investors must align their goals carefully when choosing among different types of debt mutual funds.

Returns from Debt Mutual Funds

Returns from debt funds are not fixed like FDs. They depend on:

• Interest rate movements
• Credit quality of underlying securities
• Fund duration

Debt Funds vs Fixed Deposits

When deciding between Debt Funds vs FD, remember that FDs offer assured returns, and debt funds provide:

• Better post-tax efficiency (especially after indexation benefits)
• Liquidity and flexibility
• Market-linked returns

Who Should Invest in Debt Mutual Funds?

Investors who typically benefit from debt mutual fund types include:

• Conservative investors
• Retirees seeking income stability
• Individuals with short- to medium-term goals
• First-time mutual fund investors

Understanding debt funds in mutual funds ensures realistic expectations and better financial planning.

Taxation of Debt Mutual Funds

You need to also be aware of taxation before investing in any of the types of debt funds, as post-tax returns may vary widely from headline returns. The tax rules governing debt mutual funds have been made more complex over the years in India, and they are something investors must understand. Here is a simple beginner's overview detailing the tax structure on debt mutual funds in India.

Key Change (Effective 1 April 2023)

As per the changes made in the Finance Act 2023, capital gains arising from most categories of debt mutual funds are now taxed at the investor’s income tax slab rate.

This change is also applicable to all debt mutual fund types that invest less than 35% in equity shares of Indian companies

Capital Gains Tax on Debt Mutual Funds

1. Investments Made On or After 1 April 2023

For investments made after this date:

• There is no distinction between short-term and long-term capital gains
• All gains are added to the investor’s taxable income
• Tax rate is as per the income tax slab (5%, 20%, 30%, etc.)

Example:

If you invest ₹5 lakh in one of the types of debt funds and earn ₹50,000 as profit, this ₹50,000 will be taxed as per your slab rate, just like salary income.

2. Investments Made Before 1 April 2023 (Grandfathered Rules)

For older investments, taxation depends on the holding period:

Indexation allowed investors to adjust the purchase price for inflation, significantly reducing taxable gains. This benefit continues only for investments made before 1 April 2023.

Taxation of Different Types of Debt Funds – Does Category Matter?

All the debt mutual fund types are taxed uniformly under the new rules, provided they do not meet the equity exposure threshold.

Tax Deducted at Source (TDS) on Debt Mutual Funds

• No TDS is deducted on capital gains for resident Indian investors
• Investors are responsible for declaring gains and paying tax while filing a return.

For NRIs, however, TDS may apply depending on prevailing income tax rules.

Who Is Most Affected by the New Tax Rules?

The revised taxation impacts:

• High-income investors (30% slab)
• Long-term investors who earlier benefited from indexation
• Investors using long-duration debt funds for tax efficiency

However, for short-term parking and liquidity needs, taxation changes have limited impact on the practical usefulness of many types of debt funds.

Key Advantages and Limitations of Debt Mutual Funds

Advantages

• Lower volatility than equities
• Wide variety of risk profiles
• Suitable for goal-based investing

Limitations

• Not risk-free
• Returns fluctuate
• Credit and interest rate risks exist

Knowing these aspects helps investors choose among suitable debt mutual fund types wisely.

Summing up

Understanding the types of debt funds to invest in is crucial for investors who are seeking a volatile risk and stability in their investment portfolio. They each exist for a reason, and it's important to be clear about investment horizon and risk tolerance.

At My Mudra, we explain complex financial ideas and give you the freedom to make decisions based on straightforward information. Get accurate information and expert insights, and find the best debt funds for you.

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