Debt Mutual Funds Types (SEBI Categorization Rules) – Updated 2023

You may be looking for the Best Debt Mutual Funds to invest in 2023 India. But the answer to that isn’t easy.

Different debt funds are best suited for different people. And that’s not all. These Debt funds come in various varieties. And after the SEBI doing the Categorization and Rationalization exercise in 2017-18 (more details here), there are now several categories of debt funds which end up confusing the investors.

SEBI’s idea to do the Categorization exercise was to bring some structure in the mutual fund space and help investors find the right mutual funds for their portfolios.

And to ensure that there isn’t any confusion within fund categories, SEBI had mandated that each fund house (or AMC) should have only one fund in each category.

Let’s look at the different categories and types of debt mutual funds as per SEBI’s latest Categorization and Rationalization of Mutual fund schemes.

Different Categories of Debt Mutual Funds (India) 2023

Debt mutual fund schemes have been put into 16 different categories. These debt fund types 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
• Long Duration Funds
• Dynamic Bond Funds
• Corporate Bond Funds
• Credit Risk Funds
• Banking and PSU Funds
• Gilt Funds
• Gilt Funds with 10-year constant duration
• Floater Funds

And in very simple terms, here is the basic difference between these debt fund types:

• Overnight funds – holding portfolio with maturity of up to 1 day
• Liquid funds – holding portfolio with maturity of up to 91 day
• Ultra-Short Duration – holding portfolio with maturity 3-6 months
• Low duration – holding portfolio with maturity 6-12 months
• Money market – holding portfolio of money market instruments with a maturity of up to 1 year
• Short duration – holding portfolio with maturity 1-3 years
• Medium duration – holding portfolio with maturity 3-4 years
• Medium to long-duration – holding portfolio with maturity 4-7 years
• Long duration – holding portfolio with maturity more than 7 years
• Dynamic bond – can invest across durations
• Corporate bond – atleast 80% in highest rated corporate bonds
• Credit risk fund – atleast 65% in corporate bonds below highest-rated bonds
• Banking and PSU – atleast 80% in instruments issued by banks, PSU undertakings, municipal corporations, etc.
• Gilt – atleast 80% in instruments issued by government across periods
• Gilt with 10-year constant duration – atleast 80% in instruments issued by government across periods such that average maturity is 10 years
• Floater – atleast 65% in floating rate instruments

Read more about debt fund category details on SEBI’s website here and here.

But that is not all there is to the differences amongst all debt fund types.

And before we move forward, let me tell you something – Whoever told you that debt funds are risk-free is lying. Debt funds are not risk-free. If they were, then they would not be offering potentially higher post-tax returns than actual risk-free debt instruments (like PPF, etc.). Isn’t it? To put it simply, you do get potentially higher post-tax returns in debt funds. But for that, you take higher risk, which is a fair deal.

Talking of risks, the two major risks that debt funds investors need to understand are Interest rate risk and the Credit risk of these fund categories.

More important to understand here is that of all the 16 categories of debt mutual funds defined by SEBI, only a few have strict guidelines and restrictions on interest rate risk as well as on credit risk specifications. Many have restrictions on either one of them and not both. And this is important.

What this means is best explained with an example.

Suppose you wish to find out a good liquid fund to invest in. By definition, the liquid fund has to hold papers (portfolio) that have a maturity of upto 91 days only. So this takes care of interest rate risk to a large extent, as duration is small. But the SEBI definition doesn’t restrict how much credit risk they can take. So if a Liquid Fund XYZ invests only (i.e. 100%) in Triple-A rated papers and another Liquid fund PQR invests only 60% in Triple-AAA rated papers, then obviously XYZ is safer than PQR. And since PQR is taking higher risk, it’s possible that it will be giving potentially better returns. But those incrementally higher returns are coming from high-risk taking – which may or may not be suitable for all investors.

So even within a debt fund category, different funds will take different degrees of credit or/and interest rate risk.

And it is for these reasons that picking the right debt fund for your investments is not that simple. If for whatever reason, you are unable to select the best debt mutual fund 2019 for yourself, then it may be a good idea to take proper advice from SEBI-registered Investment Advisor (SEBI RIA) or a Fee-Only Financial Planner. They can help you pick the right debt funds (as well as best equity funds) for your portfolio and financial goals. And please avoid taking recommendations from Mutual Fund Agents (Distributors) if you are unable to trust him about giving proper advice.

When it comes to taxation of debt mutual funds, the tax liability arises only at the time of sale of debt fund units. This is one of the major differences when it comes to the comparison between debt funds vs bank fixed deposits.

This is also one of the big reasons why debt funds are good for HNIs (or those in high-tax brackets) as one of the biggest advantage a debt fund offers is in the form of long-term capital gains taxation which makes a lot of difference to an HNI (high net-worth) investor from the post-tax returns perspective.

As a refresher, here is how the capital gains from debt funds are taxed:

• If debt fund units are held for less than 3 years, the capital gains is treated as short-term capital gains and taxed at the marginal income tax rate (income tax slab).
• If debt funds units are held for more than 3 years, the capital gains is treated as long term capital gains and taxed at 20% after accounting for indexation.

Talking of debt funds vs FD debate, many people, in the wake of getting the tax advantage which debt funds provide compared to FDs, tend to ignore the risks that come along with debt funds (interest and credit risk). But that is risky to your financial health.

So you shouldn’t blindly pick any debt fund category. There has to be a really good fit between your financial goals (use this FREE Financial Goal Planning Excel Download) and the type of the debt fund being selected.

And I have heard this from many people (several of whom eventually became my clients) that they find it overwhelming to choose the right debt funds from the 16 debt fund categories. No doubt debt funds are a different ball game when it comes to analyzing them from risk and credit perspective, in addition to asset allocation and goal-suitability perspective.

Pick the wrong debt fund and you may end up paying a big price very soon.

Related Reading: How to pick debt funds correctly?

It is for this reason why having a proper financial plan is the best way to go about it. Instead of trying to find the best debt fund or the best equity fund to invest in, the journey of building a mutual fund portfolio should begin with your financial goals.

It is only after the financial goals are identified and proper assessment of risk-profile and timeline linked constraints are made, only then that the mutual funds should be selected to fit in the portfolio.

Remember that each category of debt funds is suitable for a specific need over a specific time period for a given type of investor. Just because your friend or colleague is parking money in Credit Risk Funds doesn’t mean that you too should put money there. Different people will have different debt fund categories that suit them.

And let me give you a free piece of advice (though free advice should be taken with caution). Unless you are a sophisticated investor who knows what he is after, you are better off picking debt funds of shorter duration (like liquid funds, ultra-short duration funds, low duration fund, short-duration funds, etc.). You don’t really need to take the interest rate risk. But you need to be careful about the credit risk these funds take. Don’t mess that analysis.

There are different types of debt mutual funds in India (2023) and many of you don’t know how to select the right debt funds for your portfolio. If you are in a similar situation, you can talk to me under Goal-based Financial Planning service – where we begin with your goals and eventually find out the right mutual funds (equity and debt) for your portfolio.