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 –

  1. Low risk
  2. High assured returns between 7 to 8 % (which are not dependent on the market)
  3. High liquidity (you can take your money out when you need it)
  4. Low volatility (as it’s not market dependent and returns are mainly fixed)
  5. 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.

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

Debt funds are a type of investment that is not influenced by the stock market. This is because debt funds are based on lending money to a company or government, rather than investing in stocks. The interest from the loan is then used to pay the investors, which makes debt funds much less risky than equity investments. This stability makes debt funds an attractive investment for those who are looking to protect their capital.

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.

Who Should Invest in a Debt Fund?

People looking for low-risk investment opportunities may want to consider investing in a debt fund. Investors in debt funds typically seek to preserve capital and earn income through regular interest payments from the fund’s holdings. For these reasons, debt funds may be appropriate for investors who are retired or nearing retirement, as well as those who have a low tolerance for risk.

Types of Debt Funds

1. Overnight Funds


Overnight Funds

Overnight funds are investment instruments that provide investors with the opportunity to earn a return on their idle cash. It is a type of mutual fund that invests in debt instruments with maturities of one day or less.

Overnight funds are best for businessmen or entrepreneurs who frequently need to store significant amounts of money for only a brief period until it can be used for other purposes.

Overnight funds are managed by professional fund managers who use their expertise and market knowledge to generate returns for investors. Securities in these funds mature the next day, meaning these funds are less exposed to interest rate or default risk in comparison to other debt funds. Of course, this low-risk profile also means they tend to offer the least return.

2. Liquid Funds


Liquid Funds

Liquid funds are debt mutual funds that lend money to companies for up to 91 days. They are considered much safer than other types of mutual funds because of their very short lending duration. Liquid funds are ideal for people who want to save money for emergencies, as there is almost no risk of loss if the investment is held for at least one month.

Liquid funds are a good choice for those who have a lot of cash lying around that they aren't investing anywhere and who want a short-duration investment option with lower risks.

3. Ultra short-term funds


Ultra short-term funds

Ultra-short-term funds are mutual funds that invest in debt instruments with maturities of up to one year. The main advantage of investing in ultra-short-term funds is that they offer high returns with low risk. This is because these funds invest in highly rated debt instruments that have a low probability of default.

Another advantage of investing in ultra-short-term funds is that they provide liquidity. This means that you can easily withdraw your money when you need it.

4. Low Duration Funds


Low Duration Funds

Low-duration funds are debt funds that allow you to invest your money in short-term debt securities that come with an average duration of 6 to 12 months. While this may sound similar to liquid funds, these low-duration funds come with a higher credit risk because they usually hold assets of lower credit quality. This means that they have a higher interest rate and credit risk.

5. 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.

6.Short term funds


Short term funds

Short-term funds are a good option for investors who want to earn regular income without taking on too much risk.

Short-term bond funds invest in debt instruments with maturities of up to three years. The fund managers invest in a variety of debt instruments such as government securities, corporate bonds, and treasury bills. The main benefit of investing in a short-term bond fund is that it offers relatively high liquidity compared to other fixed-income options such as long-term bonds or FDs (fixed deposits).

7. Medium Duration Funds


Medium Duration Funds

Medium-duration funds are a type of mutual fund that invests in debt instruments with maturities of three to four years. These funds are considered to be less risky than long-term debt funds, but more volatile than short-term debt funds. Medium-duration funds offer higher returns than short-term debt funds, but with more risk.

Investors who are looking for stability and moderate returns may consider investing in medium-duration funds. The average return for this is around 7%; however, a savings account with FreoSave can give you the same return without putting your money at risk.

8. Medium to Long Duration Funds


Medium to Long Duration Funds

Medium to long-duration debt funds invests in securities with a maturity period of 4 to 7 years. Such funds carry high-interest rate risk, and can be a good choice when the economy is doing well, and the interest rates are falling.

9. Long Duration Funds


Long Duration Funds

Long-duration funds are mutual fund schemes in long-term government bonds and other debt instruments with maturities of 10 years and above. The primary objective of these funds is to generate income for investors through interest payments on the underlying investments.

Long-duration funds are relatively less volatile than other debt mutual fund schemes, making them ideal for risk-averse investors seeking stability in their portfolios. However, these funds also come with certain risks, such as the interest rate risk associated with long-term bonds. Nevertheless, long-duration funds can be a valuable addition to any investor’s portfolio, especially if held for the long term.

10. 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.

11. Corporate Bond Funds


Corporate Bond Funds

Corporate bond funds are like the debtors with the best possible credit rating. Companies with this high of a rating are financially strong and have a high probability of being able to pay back their lenders on time. These types of funds are ideal for people who don't need the money for at least 2 to 3 years. They often times outperform bank fixed deposits that have similar durations, and if you hold them for three or more years, you get tax-efficient returns since they qualify for indexation benefits.

12. Credit Risk Funds


Credit Risk Funds

A 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.

13. Banking and PSU Funds


Banking and PSU Funds

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.

14. 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.

15. Gilt Funds With 10-Year Constant Duration


Gilt Funds With 10-Year Constant Duration

Investment vehicles that invest in securities by the Reserve Bank of India are known as the Gilt Funds. As the name suggests, a gilt fund with a ten-year constant duration comes with a fixed maturity period of 10 years, and it is meant for people who have lower risk tolerance.

16. Dynamic Bond FundsFloating 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 or even investing in emergency funds.

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.

Not sure about investing in debt funds?
Freo Save’s digital savings bank account can also earn you great interest.

Freo Save offers you up to 7% interest depending on your balance, which is close to the interest you can earn by investing in debt funds. Plus, on opening a savings account with Freo Save, you can get access to the Freo Save debit card, which allows you to earn cash back and reward points on every spend. Keeping your money secured with a Freo Save account will also help you eliminate taxes that are charged from the gains you make with debt funds. You also get other benefits that are associated with Freo.

Open your Freo Save digital savings account today and start earning on your capital without risk.