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How to choose the best debt fund for your portfolio?

Written by - Akshatha Sajumon

January 12, 2022 8 minutes

Debt mutual funds generally offer regular interest income along with capital appreciation to investors. The investment of these funds is focused on fixed-income securities with fixed coupon payments. Therefore, investors who want to avoid equity markets usually opt for debt funds. Investors can estimate approximate returns from these funds in advance by using the coupon rate and tenure. There are multiple debt fund categories available in the market today that help investors to reasonably diversify their portfolios. But, how does one choose the best debt fund? 

Here, we will explain some of the basic functionalities and features of debt mutual funds. We will also share tips for investors to choose the best debt fund to invest in.

How do Debt Mutual Funds Work?

The fund managers of debt mutual funds invest in fixed-income securities as per the investment objective of the fund. The instruments are chosen as per their credit ratings and according to the nature of the fund. Most funds invest in instruments with high credit quality. A higher credit rating indicates timely disbursal of interest payments and a guarantee of receiving back the principal amount at maturity. 

A debt fund manager will also consider the maturity period of instruments against the interest rate outlook of the economy. If the interest rates are likely to fall, the fund manager invests in long-term securities. If, however, the interest rates may rise, investments are made in short-term securities.

What are the Different Types of Debt Funds:

  1. Overnight Funds

Overnight funds invest in securities that have one-day maturity. These funds are not impacted by interest fluctuations because of the short duration.

  1. Liquid Funds

Liquid mutual funds invest in short-term money market securities that have maturities of less than 91 days. 

  1. Ultra Short-Duration Funds

These debt funds invest in debt and money market instruments that have maturities between 3 to 6 months. These also have relatively lower interest rate risks.

  1. Low Duration Funds

Low-duration funds invest in short-term debt securities with the objective to maintain portfolio duration between 6 to 12 months. These funds invest in assets of longer maturity and lower credit quality as compared to overnight or liquid funds. 

  1. Corporate Bond Fund

These funds invest a minimum of 80% money in high-rated corporate bonds. While investing in these, investors must look out for the credit risk associated with downgraded ratings of corporate bonds, if any. 

  1. Credit Risk Fund

These funds invest 65% of the corpus in debt instruments that have credit ratings below highest credit quality. These may be riskier as compared to other debt funds because of the credit quality chosen.

  1. Gilt Funds

These invest a minimum 80% of their corpus in government securities (G Secs) with different maturities. These are ideal for investors with no risk appetite.

  1. Fixed Maturity Plans (FMPs)

Fixed Maturity Plans are close-ended funds and are available for investment only during the initial offer period. They have a lock-in period ranging from months to years. FMPs have the potential to offer superior and tax-efficient returns for long-term investors.

  1. Long Duration Funds

Long Duration Funds invest in long-term securities such as G Secs, bonds, debentures, etc. with the aim to generate steady returns in various market scenarios. 

  1. Dynamic Bond Funds

These funds invest in debt instruments from different issuers and come with dynamic maturity periods. They are ideal for investors with moderate risk appetite and those who are looking to stay invested for 3-5 years.

  1. Banking & PSU Funds

Banking & PSU Funds are open-ended debt funds that primarily invest in debt instruments of banks, Public Sector Undertakings (PSUs) and Public Financial Institutions as defined by SEBI. 

Tips to choose the right debt fund for your portfolio

Here are some important tips to pick the right debt mutual funds in a portfolio:

1. Choose according to individual investment Horizon

Investors must pick a debt fund as per their investment tenure. Those with an investment tenure of a year or less can opt for liquid funds and ultra short-term funds. For investment tenure of 1-3 years, short-term bonds make for an ideal option. Medium-term objectives of 3-5 years can be met by investing in corporate bond funds or dynamic bonds. 

Smart TipLonger the tenure, higher the chances of better returns, unless the interest rates are rising.

2. Personal investment goals

Choosing a specific debt fund depends upon personal investment goals. Whether the objective is to generate additional sources of income post retirement or having sufficient liquidity, investors must introspect on investment goals before making a selection. Some investors may invest debt funds to generate extra income apart from monthly salary.

Smart Tip – Check for alignment between mutual fund objectives and personal investment goals to maximize benefits.

3. Check for risk type and level

Debt funds may have lower risk as compared to equities. However, these funds do have credit and interest-rate risks. If a debt fund invests in low-credit quality bonds, there is a higher credit risk. There is a higher interest rate risk when the prices of the bond fall due to rising interest rates. The portfolio value may go down in case of a delay or default of interest payment and capital repayment.

Smart Tip – Do not assume that debt investment means no risk. Check for the specific risk type that the fund is exposed to vis-à-vis the fund’s investment strategy to mitigate the risk.

4. Historic returns

Debt funds are fixed-income securities. But there is no guarantee that these will provide positive returns. The fund performance is often in direct proportion to the prevailing interest rates. Always look for the historical performance of the fund as compared to prevailing market conditions during each phase. This will give a better understanding of the expected fund performance.

Smart Tip – With rising interest rates, the fund value may go down and it is therefore ideal for investment during falling interest rates. 

5. Expense Ratio of the fund

Since most debt funds are actively managed, investors have to pay a fee towards portfolio management. These are called expense ratios. Since debt funds usually have lower rates of returns as compared to equity funds, it is sensible to invest in these for a longer term. 

Smart Tip –  Higher the expense ratio, lower the actual rate of return in the hands of investors. Pick a fund that generates a better rate of return after considering the expense ratio. 

6. Applicable tax

Capital gains generated from debt funds are taxable. The tax rate is based on the holding period or the tenure for which an investor stays invested in a debt fund. 

  1. A capital gain made within three years of investment is known as a Short-Term Capital Gain (STCG). While calculating taxable income, investors must add STCG from debt funds to total income. The tax rate applicable will be as per income slab. 
  2. A capital gain made after three years or more is known as Long-Term Capital Gains (LTCG). A fixed 20% tax after indexation is applicable on LTCG from debt funds. 

Smart Tip – Pick a fund as per personal investment time horizon while also weighing the final applicable tax rate on the potential returns.


Investors must carefully weigh the mentioned parameters against the debt funds of their choice before finalising on an investment. Look for reviews of the debt fund along with its performance trend before investing in it.


  1. How to invest in a debt mutual fund?
    To invest in a debt mutual fund, you can download the Fisdom app on your smartphone and explore various fund recommendations along with their performance statistics. The app allows a seamless investment experience, especially to new investors.
  1. Which category of debt fund is best?
    Debt fund categorization is based on the investment time horizon and goals of the fund. Investors must pick a debt fund category depending on individual preferences around risk and returns.
  1. Which are the safest debt funds?
    Gift debt funds are considered the safest debt fund options since they invest in debt issued by the Government of India.
  1. Is it wise to invest in a debt fund?
    Investors who are risk averse will find debt funds as ideal investment option since these come with comparatively lower risk and lower market volatility influence than equity funds. Debt fund investments also add diversity to an investment portfolio.
  1. Are debt funds tax free?
    No, returns generated from debt funds may have short-term or long-term capital gains tax applicable as per the investment time horizon.

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