The Cautious Money-Making Approach of Debt Fund

For years, equity funds have captured all the limelight on account of a boom in equity markets. But behind the scenes, India’s debt mutual funds have built a strong foundation for investors seeking stability, liquidity, and steady income. Experts say debt funds are entering a promising new phase.

India’s debt mutual fund industry has grown consistently over the last decade and a half. The total assets under management (AUM) of all debt funds have jumped six-fold from Rs 3.68 lakh crore in FY11 to Rs 22.38 lakh crore in FY25.

The journey wasn’t smooth. The growth was slow in the early years but picked up after FY16 as institutional participation increased and liquidity in fixed-income markets improved. After a mild dip in FY23, the AUM rebounded in FY24 and FY25, showing renewed investor confidence amid volatile interest rates and stable yields.

“Debt funds are finding their place in investor portfolios again,” says Murthy Nagarajan, Head of Fixed Income at Tata Asset Management. “Investors who traditionally preferred bank deposits are realising that debt funds offer flexibility in withdrawals and portfolio stability.”

New Portfolio Trends

The way debt funds deploy money has also changed notably. Between FY20 and FY25, the total AUM of debt funds rose 70% from Rs 13.1 lakh crore to Rs 22.4 lakh crore. But what’s more interesting is where this money is going.

Government securities (G-Secs) have seen the biggest jump in AUMs with a 282% surge from Rs 1.1 lakh crore to Rs 4.3 lakh crore. Money market instruments such as treasury bills and commercial papers are up 105%, highlighting a move toward short-term and liquid instruments. Corporate debt AUM, on the other hand, fell 17%. However, PSU bonds and securitised debt grew steadily, by 45% and 76%, respectively.

The trend is clear; investors are choosing quality and safety. “Given the global uncertainty, investors should hedge by reducing risk and moving to safer investments. Corporate India’s balance sheets are strong but it’s a time to stay balanced,” says Nagarajan.

Interest Rates

Interest rates play an important role in deciding debt fund returns. The Indian economy is at an interesting phase—inflation is moderating, growth is stable, and the Reserve Bank of India (RBI) has signalled a supportive monetary policy. “CPI inflation is expected to be around 2.6% for the current year,” says Nagarajan. “This gives the RBI room to cut rates by up to 50 basis points in the coming months. With a steep yield curve, long-term bond yields look attractive. Investors could consider increasing exposure to gilt and corporate bond funds to benefit from potential rate cuts,” he adds.

“Inflation and global bond yields play a pivotal role in shaping debt fund returns. Inflation is subdued and the RBI’s stance remains dovish. If global central banks turn accommodative, long-duration Indian bonds could gain significantly,” says Devang Shah, Head of Fixed Income, Axis Mutual Fund.

Timing is the Key

So, where should investors look now? Shah says medium-duration and short-term debt funds offer good opportunities in the current environment. “Short-term funds, including corporate bond and money market, offer liquidity and relatively stable returns,” he says. “Gilt funds with active duration management can capture potential price gains if yields fall,” he adds.

Shah also suggests a barbell strategy—combining short-duration instruments for liquidity and long-duration bonds for capital appreciation. “It’s an effective way to balance stability and growth,” he adds. “Investors can use a mix of short-term bond funds, corporate bond funds, and gilt funds to capture different opportunities depending on their risk appetite and investment horizon, says Nagarajan.  

India’s fixed-income market has evolved rapidly, thanks to several policy changes and regulatory reforms. “The RBI has made liquidity management more efficient by introducing a seven-day Variable Rate Repo as the main tool for managing short-term liquidity. New frameworks for NBFC lending, MSME credit, and infrastructure finance have improved the credit ecosystem,” says Shah. He adds fiscal consolidation and stable foreign exchange management have also reduced volatility and attracted foreign inflows into the bond market. Vineet Agrawal, Co-founder of Jiraaf, a bond investment platform, highlights another major change—lowering of the threshold for investing in bonds to Rs 1,000. “This has opened the fixed-income market for retail investors. Combined with Sebi’s approval to Online Bond Provider Platforms, individual investors can now buy investment-grade corporate bonds easily and transparently,” he says.

Earlier, most retail investors could access debt markets only through mutual funds. With more retail participation, the liquidity in bond markets will improve substantially, improving the chances of earning better returns from debt funds.

Active vs Passive

With the rise of Bharat Bond ETFs and other passive debt products, many investors are wondering if passive funds are better than active ones. “Passive products are cost-effective and transparent,” says Agrawal. “However, returns from Bharat Bond ETFs have ranged between 7% and 9%, which is ideal for capital preservation but not for significant growth,” he says.

On the other hand, actively managed funds can take advantage of rate cycles and credit opportunities. “Active management is essential in debt because interest rate cycles are short,” says Nagarajan. “Fund managers can reposition portfolios quickly to benefit from changing conditions.” Shah says active strategies help manage duration risk and credit exposure.

FD vs Debt Funds

Retail investors often face confusion while choosing between debt mutual funds, direct bonds, and fixed deposits (FDs), especially after recent tax changes removed the indexation benefit for debt funds. “Some investors have shifted toward FDs or hybrid funds for predictable post-tax returns. But listed corporate bonds now stand on an equal footing with FDs in tax treatment and often deliver 3–4% higher returns without adding much risk,” says Agrawal. This makes investment-grade corporate bonds a good alternative for investors who can choose wisely. Agrawal says “many debt MFs over-diversify, which can dilute returns for small investors. For those comfortable with direct investing, carefully selected AAA to A-rated bonds can offer higher, more predictable income.”

How should investors manage credit risk while aiming for higher returns? Experts agree on one point: diversification and discipline are the key. “Investors should spread exposure across issuers, credit ratings, and maturities,” says Devang Shah. “Prioritise quality such as sovereign and AAA-rated instruments and avoid chasing yield blindly.”

Agrawal says laddering (diversification of bond maturity) is an effective way to manage credit and interest rate risk. “By investing in bonds maturing at different times, you ensure steady cash flow while reducing the impact of interest rate changes.” For those seeking guidance, professional fund managers and curated platforms can help construct well diversified, risk-adjusted portfolios.

Can you still earn 10% from fixed income in this market? “Not in a risk-free manner,” says Nagarajan. However, Vineet Agrawal suggests that investors can get close to that mark with smart allocation:

• 40% in AAA-rated bonds (7.5%) for safety

• 40% in AA-rated bonds (10%) for enhanced returns, and

• 20% in A-rated bonds (12%) for yield uplift.

“This mix balances safety and income,” he says. “With regular monitoring and laddering, retirees can generate 9–10% while preserving capital,” he says.

What Lies Ahead

The outlook for debt mutual funds is optimistic. Falling inflation, controlled fiscal deficit, and improving liquidity could drive yields lower, benefitting long-duration funds. The RBI kept the repo unchanged on October 1, but lowered its inflation outlook, opening up doors for further rate cuts. At the same time, short-term and corporate bond funds remain appealing for those seeking stability. With India’s debt market becoming deeper, more transparent, and digitally accessible, fixed income is finally shedding its image of “boring.”

“Debt funds are no longer just a parking space for idle money,” says Nagarajan. “They are now a key component of a well-balanced portfolio.” For retail investors, the key takeaway is simple, don’t ignore debt. Debt mutual funds can bring stability, diversification, and regular income to your portfolio. Whether you’re a conservative saver or a growth-focused investor, a well-planned allocation to debt can act as a cushion when markets turn volatile. And with India’s bond market maturing fast, this quiet performer may soon become the star of many balanced portfolios. 

@PrinceInMedia