Debt Funds - Debt Funds Meaning & How it Works?

Synopsis:

  • Debt funds invest in fixed-income securities like bonds and treasury bills.
  • They are low-risk, offering stable returns, ideal for risk-averse investors.
  • Funds vary by duration, from short-term liquid funds to long-term bonds.
  • Credit, interest rate, and liquidity risks affect debt fund returns.
  • Expense ratio impacts earnings, especially as debt funds offer lower returns than equities

Overview

Debt funds invest in fixed-income securities like treasury bills, commercial papers, corporate bonds, and government securities. These instruments have a set maturity date and offer a fixed interest rate payable upon maturity. Since market fluctuations do not influence the returns from debt funds, they are considered a low-risk investment option.

How do Debt Mutual Funds work?

Each debt security is assigned a credit rating that helps investors assess the risk of the issuer defaulting on the repayment of principal and interest. Debt fund managers use these ratings to evaluate the quality of the debt instruments. A higher credit rating indicates a lower likelihood of the issuer defaulting on its financial obligations.

Do Debt Funds also have low-quality debt instruments as part of their assets?

Yes, it is likely that Debt Mutual Funds may have invested in low-quality debt instruments. A low-quality debt instrument offers an opportunity to earn higher returns and the fund manager could decide to take a chance. However, a Debt Fund with high-quality instruments in the portfolio would have greater stability. A fund manager chooses long-term or short-term debt securities depending on whether the interest rates will likely rise or drop.

Who should invest in Debt Funds?

Debt Funds are ideal for risk-averse investors, offering stable returns by investing in diverse securities. While returns aren’t guaranteed, they typically fall within an expected range, making them suitable for cautious investors.

  • Short-term Investors (3-12 Months): Instead of parking your money in a Savings Bank Account, you can invest in a liquid fund offering 7-9% returns.
  • Medium-Term Investors (3-5 Years): For those looking for a risk-averse option for an investment horizon of 3-5 years, a bank FD is the first thing that springs to mind. However, investment in a dynamic bond fund for an equal tenure will offer higher returns than the bank FD. Investors also have the option of a Monthly Income Plan if they want monthly payouts akin to interest on FDs.

Types of Debt Funds

Given below is a classification of Debt Funds based on the maturity period:

Liquid Funds

These invest in money market instruments with a maturity of up to 91 days, offering higher returns than savings accounts, making them ideal for short-term investments.

Money Market Funds

Money Market Funds invest in instruments with a maturity of up to 1 year. They are suitable for investors seeking low-risk, short-term securities.

Dynamic Bond Funds

Dynamic Bond Funds adjust their investment in debt instruments of varying maturities based on interest rate fluctuations. Ideal for investors with moderate risk tolerance and a 3-5 year horizon.

Corporate Bond Funds

At least 80% of these funds are invested in high-rated corporate bonds, making them a low-risk option for those seeking stable, high-quality corporate investments.

Banking and PSU Funds

These funds allocate at least 80% of assets to debt securities issued by banks and public sector undertakings (PSUs), ensuring stability and safety.

Gilt Funds

Gilt Funds invest at least 80% of their corpus in government securities with different maturities. While they carry no credit risk, interest rate risk can be high.

Credit Risk Funds

These invest at least 65% of their corpus in corporate bonds with slightly lower credit ratings. They offer higher returns but carry increased risk.

Floater Funds

Floater Funds invest at least 65% of their assets in debt instruments with floating interest rates, minimising interest rate risk.

Overnight Funds

These invest in securities maturing within a day, offering ultra-safe options with minimal credit and interest rate risks.

Ultra-Short Duration Funds

Investing in money market instruments and debt securities, these funds have a Macaulay duration of 3-6 months, providing a balance between short-term safety and returns.

There are also Medium Duration Funds (Macaulay duration 3-4 years), Medium to Long Duration Funds (4-7 years), and Long Duration Funds (over 7 years), catering to different investment horizons.

Risks associated with Debt Funds

Debt Funds come with three main types of risks:

  • Credit Risk – The risk that the issuer may default on repaying the principal and interest amounts.
  • Interest Rate Risk – The risk that changes in interest rates will cause fluctuations in the value of the securities held by the fund.
  • Liquidity Risk – The risk that the fund may not have enough liquidity to meet redemption requests, leading to potential delays or challenges in withdrawing investments

Other parameters of Debt Funds

Returns of Debt Funds

Debt Funds offer lower returns than equity funds. Even the returns are not guaranteed. The NAV of Debt Funds varies with the rates of interest. The NAV of a Debt Fund is inversely proportional to the interest rates. It falls when rates of interest rise and vice-versa.

Expense Ratio

The expense ratio is what percentage of the Debt Fund’s total assets are diverted towards fees to manage the fund. Debt Funds don’t offer high returns; therefore, a high expense ratio could negatively impact your earnings.

What is your investment plan?

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Debt Funds come with varying durations, ranging from as short as 1 day (Overnight Funds) to over 7 years (Long Duration Funds). Choosing the right fund depends on your financial goals and investment timeline. Many investors favour Debt Funds as a means to generate regular income.

Some investors divert a part of their portfolio towards a Debt Fund for reasons of stability.

Regardless of what your objective is, invest according to an investment plan.

Looking to invest in a Debt Mutual Fund? Click here to get started.

*Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances.