Debt Funds - Debt Funds Meaning & How it Works?
Debt Funds are ones which invest in securities that generate a fixed income such as treasury bills, commercial papers, corporate bonds, government securities and many other instruments related to money markets. The instruments that the debt fund chooses to invest have a fixed date of maturity and an interest rate that the buyer will receive on maturity. Because the returns of a debt fund don’t vary with market conditions, debt securities are considered to be a low-risk option for investment.
How do Debt Mutual Funds work?
Every debt security has a credit rating which helps an investor to estimate the probable risk of the debt issuer defaulting in disbursing the principal and the interest amount. Debt Fund managers are able to determine the quality of the debt instrument after looking at these ratings. A higher credit rating on a debt security would mean that the probability of the issuer defaulting on its obligations is low.
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 are likely to rise or drop.
Who should invest in Debt Funds?
Debt Funds are meant for those who have an aversion for too much risk. Debt Funds invest in diverse securities and offer stable returns. Though there is no guarantee, the Debt Funds usually generate returns in an expected range. Therefore, risk-averse investors find them suitable. Debt Funds can also be considered by:
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) – 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.
Given below is a classification of Debt Funds based on the maturity period:
Liquid Funds – Liquid Funds are invested in money market instruments with a maximum maturity period of 91 days. Liquid Funds usually offer higher returns than a savings bank account and are an excellent option for short-term investment.
Money Market Fund – A Money Market Fund invests in money market instruments with a maximum maturity of 1 year. These funds are ideal for investors scouting for low-risk debt securities over the short term.
Dynamic Bond Fund – A Dynamic Bond Fund invests in debt instruments with different maturities depending on the prevailing interest rate scenario. These funds are good for investors who have only a moderate appetite for risk and who have an investment horizon of 3-5 years.
Corporate Bond Fund – A Corporate Bond Fund invests a minimum of 80% of its total assets in corporate bonds with highest ratings. These funds are ideal for investors with a low-risk appetite and want to invest in corporate bonds of the highest quality.
Banking and PSU Fund – A Banking and PSU Fund invests at least 80% of its assets in debt securities issued by public sector undertakings (PSUs) and banks.
Gilt Fund – A Gilt Fund invests a minimum of 80% of its total corpus in government securities of varying maturities. There is no risk associated with these funds but the interest rate risk is high.
Credit Risk Fund – A Credit Risk Fund invests at least 65% of its investible corpus in corporate bonds whose credit ratings are just a shade below highest quality corporate bonds. Due to this, these funds offer higher returns than highest quality bonds but is associated with a certain amount of risk.
Floater Fund – A Floater Fund invests at least 65% of its total assets in debt instruments that offer a floating rate of interest. These funds have a low interest rate risk.
Overnight Fund – An Overnight Fund is a kind of Debt Fund that invests in debt securities maturing in 1 day. These funds are considered to be ultra safe because both credit risk and interest rate risk is negligible.
Ultra-Short Duration Fund – An Ultra-Short Duration Fund is a Debt Fund that invests in money market instruments and debt securities in a way that the Macaulay duration of the scheme is between 3 and 6 months. For a lay person, Macaulay duration is the the time an investor would need to get back all his invested money in the bond by way of period payment of interest and repayment of the principal amount.
Similarly, there are Medium Duration Funds (Macaulay duration between 3-4 years), Medium to Long Duration Funds (Macaulay Duration between 4-7 years) and Long Duration Funds (Macaulay Duration is more than 7 years).
Risks associated with Debt Funds
Debt Funds are fundamentally associated with three kinds of risks:
Credit Risk – This is the risk of the issuer not repaying the principal and interest.
Interest Rate Risk – This risk is the fluctuation in the value of the securities in the scheme with change in interest rates.
Liquidity Risks – This is defined as the risk when a fund house may not have sufficient liquidity to fulfill or meet redemption requests.
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. NAV of a Debt Fund is inversely proportional to the interest rates. It falls when rates of interest rise and vice-versa.
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 and therefore a high expense ratio could negatively impact your earnings.
What is your investment plan?
Debt Funds with all kinds of durations are available; from 1 day (Overnight Funds) to 7+ years (Long Duration Funds). Which one to choose while investing in Debt Funds will depend on your financial goals and investment horizon. Many investors opt for Debt Funds with an objective of earning 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.
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*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.