All You Need to Know About Investing in Debt Mutual Funds

Debt Mutual Funds

A spate of recent payment defaults and bankruptcies have crippled the average mutual fund investor’s confidence when it comes to investing in debt instruments. Investors do factor in risk and volatility in some debt mutual funds but almost never in liquid funds, low duration and ultra short term mutual funds. In this post, we shall examine the different types of debt instruments, which works best in what situation, risk in debt instruments, taxation in debt funds and the debt mutual funds you can seek to purchase.

What are Debt Mutual Funds?

Debt mutual funds are those types of mutual fund schemes that invest in fixed income instruments like government bonds, corporate bonds, debentures, money market instruments etc. The primary objective of debt funds is to protect your capital with adequate appreciation in capital and is ideal for risk-averse investors who aim for regular income. Debt instruments are also preferred by corporate institutions, insurance and pension companies for their low cost structure, high liquidity, reasonable safety and stable returns.

The Indian mutual fund industry has seen excellent offtake of debt funds with the AUM crossing well over ₹13,00,000 crores

Advantages of Investing in Debt Mutual Funds

Debt mutual funds offer many advantages which include –

  1. Meeting short-term goals like paying a child’s school fees or having an emergency fund or a goal ranging from 1 month to 3 years 
  2. Liquidity availability allowing investors to withdraw from funds without being penalized on withdrawals
  3. Tax benefits when investors stay invested for over 3 years
  4. Regular Income on a monthly or quarterly withdrawal plan basis in a tax efficient manner with Systematic Withdrawal Plans
  5. Diversification of portfolio by reducing volatility and offering stable returns
  6. Potential to earn higher returns as compared to traditional options like a savings bank account

What is the Difference between Debt Mutual Funds and Fixed Deposits?

Real estate and Fixed deposits at banks have long been the default mode of investing in ‘safe’ instruments for the Indian risk-averse investor. But in the last few years, debt mutual funds have offered a promising instrument of choice to the growing masses of millennial investors in the country with greater choice, flexibility, liquidity and returns.

Debt mutual funds and fixed deposits have many points of comparison as examined in the table below.

Are Debt Funds Risk Free?

No. Debt funds are not risk-free. 

The de facto risk-free fixed income instrument is the bonds issued by the central government. But even these don’t hold much stead as we have seen in countries such as Argentina, Greece, Iceland, Russia and Mexico. Assuming we aren’t going to see a default of this nature, we can assume that the Government of India bonds are super-safe or risk-free for all practical purposes. Perhaps this is why you see the lowest interest rate on these papers.

Risk & Return – The Yin and Yang of Debt Funds

Types of Risks in Debt Funds

Risk in debt funds come from two primary concerns –

  1. Risk of default in interest payment and/or principal
  2. Risk of changes in interest rate 

Risk of default in interest payment and/or principal talks about the safety of capital. If the underlying security were unable to have enough liquidity or cash in its books to pay off your loan when demanded or at the due date then an event called credit default is initiated which leads to investors losing their entire principal or some part of it due to drop in prices of those bonds. 

The image below shows the price of DHFL NCD (non convertible debentures) prices on 9 June 2019. All these bonds were issued at ₹1,000 but are languishing at a discount of 25-55%. This price drop was due to DHFL missing out on some payments which put a massive question on its ability to service the debt obligations that it had on its books. In other words there was a high credit default risk on this instrument.

DHFL NCD prices were trading at much below that issuance price of ₹1,000 in June 2019
DHFL NCD prices were trading at much below that issuance price of ₹1,000 in June 2019

Risk of changes in interest rates are always there as any changes to the government’s risk-free rate (also called repo rate or other names like benchmark rate or MCLR etc.) has an instant effect on the pricing and the yields of the bonds and therefore, the debt mutual funds. Let’s understand this broadly.

Why bond prices fall when interest rate rises? When the Government of India increases the interest rates, it makes the existing bonds which were offering lower interest rates less desirable. This lowers the demand for these bonds thereby reducing the price of these existing bonds. For more information on interest rates, do read my post on 10 Stocks to Buy & Sell when Interest Rates Change

Can Debt Mutual Funds give Negative Returns?

Yes, debt mutual funds can give negative returns. This happens when the scheme has been hit with risks associated with default in the underlying papers like bonds, debentures etc. or when hit with risks associated with interest rate changes. 

Let’s examine this with a couple of examples

UTI Credit Risk Fund has over ₹1,400 crores in AUM which has done rather well over the last few years with returns of 7.70% in 2013, 11.46% in 2014, 8.86% in 2015, 10.30% in 2016, 6.90% in 2017 and 5.45% in 2018. The year 2019 and onwards has been a horrible period for the UTI Credit Risk Fund as they had to markdown the Jun 2019, Sep 2019 and Jan 2020 due to exposures on –

  • DHFL (Jun 2019)
  • Altico Capital (Sep 2019)
  • Vodafone Idea (Jan 2019) 

Net net, the UTI Credit Risk Fund is down by 14.62% over the last one year which is one of the biggest drops in debt funds I have seen in the last 5 years.

UTI Credit Risk Fund NAV is down by 14.62% showing debt funds also carry certain amount of risk
UTI Credit Risk Fund NAV is down by 14.62%

HDFC Gilt Fund is a ₹1,200 crores sized fund with the objective of generating reasonable returns by investing in government securities (or guaranteed by government securities) with medium to long term maturities. This means taking a view on the bonds whose maturity is anywhere from 3 to 10 years away which makes the fund subject to swings in prices as seen in the chart below.

HDFC Gilt Fund has delivered negative returns in three of the last 12 quarters

The HDFC Gilt Fund has delivered negative returns in three of the last 12 quarters with returns of -0.90% in the Jan-Mar 2017 quarter, -1.55% in the Oct-Dec 2017 quarter and -0.81% in the Apr-Jun 2018 quarter. To put that into perspective, if a user had invested money in this fund on 05-Jan-2017 and checked the portfolio performance almost an year later (on 28-Dec-2017), the investor would have made negative returns. 

Thus, certain debt mutual funds are less risky while some carry a much higher risk element to them which means some debt funds can go into negative territory for certain time periods

How Debt Funds offer Returns?

Debt funds primarily follow two strategies to deliver returns to investors – 

  1. Accrual strategy
  2. Duration or Capital appreciation strategy

An accrual strategy of earning returns on debt funds is primarily dependent on interest income. The aim of the fund manager is to generate returns by earning higher yield which requires managing the credit risk while minimizing interest rate risk. This strategy is generally followed by shorter maturity funds like liquid funds, ultra-short term funds, short-term debt funds and income funds. These funds typically hold the papers until maturity and reinvest the proceeds into fresh issues.

A duration strategy of earning returns on debt funds is focused more on capital appreciation that happens when bond prices rise due to a fall in interest rates. This strategy does not give much credence to interest income which is the mainstay of the accrual strategy. The fund manager aims to generate returns by actively managing interest rate risk by investing in long term debt instruments like gilt funds.

Accrual and duration strategies in debt funds relate to different investor goals. 

  • If you are looking at regular income, then you are better off with an accrual strategy.
  • However if you are a first time investor, it is better for you to lean on duration strategy funds because accrual funds carry a bigger risk as defaults or rating downgrades can devastate a fund’s NAV (refer to the chart on UTI Credit Risk Fund above)

What are the Different Types of Debt Mutual Funds?

The types of debt mutual funds from which investors can choose from are –

  • Overnight funds
  • Liquid funds
  • Ultra Short Duration funds
  • Low Duration funds
  • Money Market funds
  • Short Duration funds
  • Medium Duration funds
  • Medium to Long Duration funds
  • Gilt funds
  • Long Duration funds

Debt mutual funds are classified on the basis of their indicative investment horizon and their investment strategy. Investors can choose a debt fund based on the time horizon, liquidity needs and their risk appetite. 

Return expectation, risk appetite and investment horizon are the three primary parameters when choosing a debt mutual fund
Return expectation, risk appetite and investment horizon are the three primary parameters when choosing a debt mutual fund

Let’s understand each of these debt funds as described in the table below

Some Useful Tips on How to Choose Your Suitable Debt Fund

  1. Make capital protection your primary object when investing in debt funds – New investors often chase returns in debt funds with a flawed assumption that debt funds are a source of making plentiful wealth. This is not the case. With every investment in debt fund make sure you ask yourself the question – “will I lose money?” 
  2. Your needs should match the duration of the fund – Don’t buy a long-term fund like a gilt fund if your investment horizon is only 3 months. You will be better served with a liquid fund or ultra short duration funds. Refer to the investment horizon column in the table above to choose the right type of fund
  3. Set your risk and return expectations before investing – While credit risk funds that invest in low rated securities offer potentially higher returns, they come with commensurate risk which comes in the form of a credit downgrade or default. If you don’t have a high risk appetite, then opt for funds that invest in AAA securities only which’ll offer you better risk but at a lower return
  4. Diversify well – It is good sense to choose funds across complementary debt fund buckets like accrual strategy v duration strategy, money market v gilt funds etc. after a clear assessment of your needs and risk-return expectations. It is a well-known fact that the highest risk-adjusted returns go to a well-diversified portfolio across assets rather than choosing a particular fund

Performance of Debt Funds

It has truly been a tale of two cities. Credit funds have seen a lot of stress in the debt mutual fund category and have performed negatively over the last one year with the average credit risk fund yielding -0.23% returns over the last one year. On the other hand, long duration debt funds and Gilt with 10 year Constant Duration have performed exceedingly well to the extent that no equity fund has been able to top the returns that these two category of debt funds have offered.

I have compiled a list of trailing returns of debt funds over 1 year, 3 years, 5 years and 10 years in the table below (as on 19th Jan 2020)

Best Debt Mutual Funds for 2020

The Best Overnight Funds for 2020 are –

  1. HDFC Overnight Fund
  2. SBI Overnight Fund
  3. UTI Overnight Fund

All the above funds have an AUM of atleast ₹2,000 crores and the fund managers have been managing these overnight funds for over 6 years now.

The Best Liquid Funds for 2020 are –

  1. Franklin India Liquid Fund
  2. Nippon India Liquid Fund
  3. ICICI Prudential Liquid Fund

Liquid funds are fashioned to not take unnecessary credit risk to improve returns. Capital protection is the primary objective here but yet, in a bid to chase higher returns, some liquid funds invest in low-rated instruments that promise higher yields. To avoid these scenarios, SEBI has changed the valuation norms of liquid funds since mid-2019. Per the new rules, funds have to mark-to-market i.e. the value of the fund should be on the existing market prices, all holdings with maturities over 30 days from the earlier 60 days. As a result, fund managers have started to favour 30-day maturities which lowers the potential gains due to the shorter maturity.

The Best Ultra Short Duration Funds for 2020 are –

  1. SBI Ultra Short Duration Fund
  2. ICICI Prudential Ultra Short Duration Fund
  3. Kotak Savings Fund

Ultra Short Duration debt funds are a popular category with millenials investors with the category AUM crossing ₹1,00,000 crores. These funds invest in bonds maturing in 3 to 6 months and aim to earn slightly better returns when compared to a bank fixed deposit which makes them attractive. While the risk of incurring a loss is quite low we, as recent as 16 January 2020, saw a serious drop in NAV of one of the more popular picks in this category – Franklin India Ultra Short Duration Fund – whose NAV dropped by 4.3% in a single day thereby wiping out its gains over the last six months. This happened due to the default risk emerging from the 8.25% Vodafone Idea 2020 paper they held which was a BBB- rated instrument. 

The Best Low Duration Funds for 2020 are –

  1. Kotak Low Duration Fund
  2. Aditya Birla Sun Life Low Duration Fund
  3. HDFC Low Duration Fund

The Franklin Low Duration Fund has seen a drop in NAV for two months in a row – with Essel Infraprojects in December 2019 and then with Vodafone Idea in January 2019. Since 3-Dec-2019 until now, the fund has lost 7.7% in value. The difference between Franklin Low Duration Fund and the ones from Kotak, Aditya Birla and HDFC as suggested above has been their penchant to take higher risk and invest in AA or even lower papers. The Essel Infraprojects and Vodafone Idea bonds were rated BBB- by rating agencies but the fund from Franklin India held them as they offered higher yields. When choosing a low duration fund, it is better to check the portfolio and opt for funds which have more AAA and A1+ rated papers

The Best Money Market Funds for 2020 are –

  1. L&T Money Market Fund
  2. Nippon India Money Market Fund
  3. ICICI Prudential Money Market Fund

Money Market funds invest in bonds with a maturity of upto one year and happen to be one of my favourite debt instruments if chosen with care. They generally offer returns in the 7.5-8.5% range with a high level of predictability if investments are made in funds which employed high rated securities in their portfolio. 

The Best Dynamic Bond Funds for 2020 are –

  1. Kotak Dynamic Bond Fund
  2. ICICI Prudential All Seasons Bond Fund
  3. SBI Dynamic Bond Fund

Dynamic Bond funds have the flexibility to invest in bonds of any duration. It is advised that these bonds are held for a period of atleast 3 years but a word of caution that dynamic bond funds come with their fair share of risk. There are credit calls, liquidity calls and interest rate calls that the fund manager has to take. The UTI Dynamic Bond Fund have had many troubles over the last one year with a negative performance of 2.6%.

Taxation Structure on Debt Mutual Funds

Any kind of capital gains made on debt mutual funds is taxable. If you were to redeem a debt mutual fund before 36 months of its purchase, then tax will be charged on the capital gains (called short term capital gain) at your prevailing income tax slab. However, if you were to redeem after 36 months of purchase, then tax will apply on the capital gain (long term capital gain) at 20% with the benefit of indexation.

Let’s understand this better with an example.

Short term capital gain in debt funds

You purchased ₹1,000 worth of units in a debt fund on 01-Jan-2015 and sold all these units on 30-Sep-2016 at a price of ₹1,200. Since the sale was effected within 36 months, short term capital gain shall apply which shall be at your current income tax slab of 30%


  • Sale price = ₹1,200
  • Purchase price = ₹1,000
  • Short term capital gain = ₹1,200 – ₹1,000 = ₹200
  • Tax slab applicable = 30%
  • Tax to be paid = ₹200 * 30% = ₹60

Long term capital gain in debt funds

In this scenario, you purchased ₹1,000 worth of units in a debt fund on 01-Jan-2015 and sold all these units on 15-Feb-2018 at a price of ₹1,600. Since the sale was effected post 36 months, long term capital gain shall apply.

It is also important to know the cost inflation index for the financial year when the units were bought and when the units were sold. The cost inflation index for FY2014-15 (applicable on the purchase of 01-Jan-2015) was 240 and that of FY2017-18 (applicable on the sale of 15-Feb-2018) was 272.


  • Sale price = ₹1,600
  • Purchase price = ₹1,000
  • Indexed purchase price = ₹1,000 * (272 / 240) = ₹1,133
  • Long term capital gain = ₹1,600 – ₹1,133 = ₹467
  • Tax slab applicable = 20%
  • Tax to be paid = ₹467 * 20% = ₹93.4 

A very useful tip

I would have ideally postponed my sale of the debt fund units by another 45 days into April 2018 as it would have pushed my sale into FY2018-19 which would have added an additional year into my cost inflation index calculation thereby lowering my taxes even further. Let’s understand this extending our previous illustration assuming that the sale price on 2-Apr-2018 is still at ₹1,600. The cost inflation index for FY2018-19 is 280.


  • Sale price = ₹1,600
  • Purchase price = ₹1,000
  • Indexed purchase price = ₹1,000 * (280 / 240) = ₹1,166
  • Long term capital gain = ₹1,600 – ₹1,166 = ₹433
  • Tax slab applicable = 20%
  • Tax to be paid = ₹433 * 20% = ₹86.6 

This is one reason why we see a decent spike in purchase of debt funds in the month of March each year and selling of debt funds in the month of April.

Cost Inflation Index Table for Calculating Indexation

The table below shows the cost inflation index table from the year 2001-02 to 2019-20

The cost inflation index table is available on the Income Tax India website.


  1. The debt mutual fund market is as big as the equity mutual fund market in India
  2. Debt funds are not risk-free and some category of debt funds carry considerable amount of risk as shown in many examples over the post
  3. Two key risks that a debt mutual fund is exposed to are interest rate risk and credit risk
  4. A debt mutual fund earns returns using an accrual and/or duration strategy
  5. Indexation benefits can be used to reduce the tax to be paid on capital gains

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