What are Debt Funds? Debt Mutual funds invest in fixed-income securities such as corporate bonds, government securities, money market instruments, etc. These funds are also known as income funds or bond funds. The difference between the purchase price and the selling price of the securities adds to the NAV of the fund. If the fund bought security for Rs 1000 and had to sell it in extreme market conditions at Rs 900 by making a loss, it results in the depreciation of the NAV. How do debt funds make money? Debt funds earn through capital appreciation and interest income from fixed-income securities. Consider that a debt fund receives 10% interest per annum; this is divided by 365 and is added to the NAV every day. A debt fund’s NAV hence depends upon the interest rate and the credit rating of its portfolio. If the credit rating of one of the securities that a fund is invested into goes down (due to default), the NAV of the fund also depreciates. The interest rate regime also has an effect on the NAV of the fund. For example, if a fund ABC holds security that offers 8% interest. If the RBI announces a decrease in the interest rates, then any new security would adhere to these new regulations and offer a lower interest rate. This would drive up the demand for pre-existing securities which were offering a higher rate (similar to our security which offered a rate of 8%). Consequently, the price of these bonds/securities would increase, leading to an increase in the NAV of the fund. Types of Debt Funds In the following paragraphs, we aim to provide 2 top-performing funds in each of the debt fund categories and also aim to provide insights on which category would be ideal for you. 1. Liquid & Money Market Funds These funds invest in money market securities with a maturity lower than 91 days. They are considered to be a good alternative to savings accounts and fixed deposits as they offer higher returns and are tax-friendly (when compared to traditional instruments). They have a reasonable level of safety of the invested principal, coupled with liquidity. They typically do not have exit loads. Investor If you have surplus cash or a sudden influx of money – sale of real estate property, bonus, or something similar, instead of parking it in a savings account and earning a meager 4% return, you could consider Liquid funds as an alternative. These are also suitable for risk-averse investors and for investors looking for stable returns and liquidity. Scheme Name1-year ReturnAUMProsConsQuant Liquid Fund4.85%Rs 174.84 CrHave higher 1-year, 3-year, and 5-year returns than the category average.The age of the fund is greater than 3 years.A high expense ratio of 0.62% (could potentially dent your earnings). AUM is less than Rs 1000 Cr, where investors need to keep an eye on the expense ratio as the fees for the operation of the fund are collected from a small base of investors.IDBI Liquid Fund Rs 1114.21 CrHave higher 1-year, 3-year, and 5-year returns than the category average.The age of the fund is greater than 3 years.The expense ratio is on the lower end – 0.13%.AUM is slightly higher than Rs 1000 Cr, where investors need to keep an eye on the expense ratio as the fees for the operation of the fund are collected from a small base of investors. 2. Gilt Funds Gilt funds invest in Government securities of State and Central governments with different bond tenures (or varying maturities) such as 1-year, 3-year, 10-year, etc. Government bonds are considered to be risk-free and have a zero probability of default (Credit risk is zero). However, these funds are subject to interest rate risk i.e., the portfolio’s worth appreciates or depreciates depending on the interest rate regime in the economy. Investor These are suitable for a risk-averse investor. They are beneficial in a falling interest rate environment as these funds would have underlying securities which would carry a high coupon. Scheme Name1-year ReturnAUMProsConsICICI Prudential Gilt FundExpense Ratio: 0.61%Min SIP Amount:Rs 100011.12%Rs 4,086.85CrHave higher 1-year, 3-year, and 5-year returns than the category averageExit Load is ZeroNoneDSP Government Securities FundExpense Ratio: 0.54%Min SIP Amount: Rs 50010.36%Rs 444.52 CrHave higher 1-year, 3-year, and 5-year returns than the category averageExit Load is ZeroNoneEdelweiss Government Securities FundExpense Ratio: 0.41%Min SIP Amount: Rs 50012.07%Rs 88.68 CrHave higher 1-year, 3-year, and 5-year returns than the category averageExit Load is ZeroAUM is slightly higher than Rs 100 Cr, where investors need to keep an eye on the expense ratio as the fees for the operation of the fund is collected from a small base of investors. 3. Short-Term Funds Funds that invest in securities that have a maturity of 1-3 years with high liquidity. The fund invests in corporate bonds, certificates of deposit, commercial paper, and government securities with medium and long-term maturities. They are prone to a lower interest rate risk when compared to medium and long-term funds. This aids the funds to sail through adverse market conditions. Investor They are ideal for risk-averse investors who aim to receive higher post-tax interest or returns (when compared to FDs). When the investment horizon is greater than 1 year. Scheme Name1-year ReturnAUMProsConsAditya Birla Sun Life Short-Term FundExpense Ratio: 0.39%Min SIP Amount: Rs 10012.00%Rs 7,001.71 CrHave higher 1-year, 3-year, and 5-year returns than the category average.Exit Load is ZeroThe expense ratio is on the lower endNoneICICI Prudential Short-Term Fund Expense Ratio: 0.44% Min SIP Amount: Rs 10010.92%Rs 22,254.84 CrHave higher 1-year, 3-year, and 5-year returns than the category averageExit Load is ZeroThe expense ratio is on the lower endThe AUM of the fund is greater than Rs 20,000 Cr. After crossing this benchmark, the returns of the fund tend to be stagnated or experience a downturn 4. Medium-Term Funds Funds that invest in securities that have a medium-term maturity of 3-4 years. SEBI mandates that these funds invest in securities that have a Macaulay duration of 3-4 years. They earn higher post-tax returns when compared to a 5-year bank FD. One can also choose to opt for monthly income plans if one wishes to receive a periodic income from their investments. Investor They are ideal for risk-averse investors who aim to receive higher post-tax interest or returns (when compared to FDs). They are also ideal for the diversification of risk. They are lesser volatile when compared to equity funds and are also lesser prone to interest rate risk when compared to long-term funds.  Scheme Name1-year ReturnAUMProsConsSBI Magnum Medium Duration FundExpense Ratio: 0.68%Min SIP Amount: Rs 50010.88%Rs 8,505.15 CrHave higher 1-year, 3-year, and 5-year returns than the category averageNoneICICI Prudential Medium Term Bond FundExpense Ratio: 0.73%Min SIP Amount: Rs 100011.12% Rs 6,437.31 CrHave higher 1-year, 3-year, and 5-year returns than the category averageNone 5. Dynamic Bond Funds Funds are actively managed or employ a dynamic investment/asset allocation strategy by reducing the average portfolio duration (or maturity) in increasing interest rate environments and increasing the duration in a falling interest rate regime. These funds hence provide an option to the investor to earn from the interest rate fluctuations. Investor They are suitable for investors who would like to stay invested for the long term without worrying about the interest rate movements affecting their wealth creation.   Scheme Name1-year ReturnAUMProsConsAxis Dynamic BondExpense Ratio: 0.25%Min SIP Amount: Rs 100010.88%Rs 8,505.15 CrHave higher 1-year, 3-year, and 5-year returns than the category averageExit Load is zeroThe expense ratio is on the lower endNoneKotak Dynamic Bond FundExpense Ratio: 0.47%Min SIP Amount: Rs 100011.12% Rs 6,437.31 CrHave higher 1-year, 3-year, and 5-year return than the category averageExit Load is zeroThe expense ratio is on the lower endNone 6. Credit risk funds These funds allocate 65% of their total assets for the purchase of lower-rated securities (lower than AA- credit rating) and offer higher returns to their investors. The credit risk is higher for these funds. The interest rate risk is comparatively lower as these funds invest in securities with low maturities. The funds also gain from capital appreciation if the underlying security is upgraded to a higher credit rating. Investors These are only suitable for investors who are willing to take a higher risk. This is due to the lower credit securities as a part of the portfolio which have a higher probability of default. Scheme Name1-year ReturnAUMProsConsICICI Prudential Credit Risk FundExpense Ratio: 0.90%Min SIP Amount: Rs 100010.01%Rs 7,209.19 CrHave higher 1-year, 3-year, and 5-year returns than the category averageNoneHDFC Credit Risk Debt FundExpense Ratio: 1.06%Min SIP Amount: Rs 50011.25% Rs 7,315.34CrHave higher 1-year, 3-year, and 5-year returns than the category averageThe expense ratio is on the higher end FAQs What are debt funds? A debt fund is a mutual fund that invests in fixed-income instruments such as treasury bills, commercial paper, government bonds, corporate bonds/debentures, money market instruments, etc. What are the benefits of debt funds? High Liquidity Investment Horizon Higher Returns Tax Efficiency Flexibility Who should invest in debt funds? Debt funds are for investors looking for a passive and regular income. These are ideal for risk-averse investors who prefer Is it good to invest in debt funds? Yes, debt funds are a great investment option for investors. These offer higher returns over a long investment horizon and are tax efficient as well. Which are the best debt funds to invest in now? Here are the best debt funds to invest in:Aditya Birla Sun Life Low Duration FundNippon India Money Market FundICICI Prudential Ultra Short-Term FundAxis Ultra Short-Term Fund How Do Debt Funds Make Money? Debt funds earn through capital appreciation and interest income from fixed-income securities. Consider that a debt fund receives 10% interest per annum; this is divided by 365 and is added to the NAV every day. A debt fund’s NAV hence depends upon the interest rate and the credit rating of its portfolio. If the credit rating of one of the securities that a fund is invested into goes down (due to default), the NAV of the fund also depreciates. Conclusion Debt funds provide a low risk to investors, while still getting investors better returns than fixed deposits. It is important to note that the previous performance of any fund isn't surety of the fund's future performance. You can start your research as well as investments on the EduFund app!