Mutual fund investments broadly cover equities and debt investments. Between these, equities are largely opted by investors with a higher risk appetite, while debt funds are preferred by those who are mostly risk-averse. Debt mutual funds invest across several debt instruments that enable investors to fetch returns in the form of interest income. While debt mutual funds come with lesser risk as compared to equity investments, these usually offer lower returns vis-à-vis equity investments.
So, how exactly does a debt fund generate returns for investors? How does it work? Here, investors who want to explore this investment category and want to understand more about debt funds can find out how these work and how they can earn returns from debt funds.
What is a debt fund?
A debt fund:
- invests primarily in fixed-income instruments like bonds, certificates of deposit, treasury bills, government securities,etc.
- involves pre-determined interest rate announced at the time of investment
- has a fixed maturity period ranging from 1 day to 7 years
- is considered less risky since its returns aren’t impacted by market movements, unlike equity funds
- offers returns or profits apart from giving back the principal investment amount
How do debt funds work?
Understanding the concept of bonds
Whenever a company wants to arrange for short-term capital to meet its growth or expansion needs, it may turn towards debt to maintain an acceptable debt-to-equity ratio. Similarly, governments, both state and central, may require funds for various infrastructural or development projects. For this, it will look to borrow from a lender.
Companies and governments can turn towards banks to raise their required capital. Alternatively, they can borrow money by issuing bonds.
Investing in bonds through mutual funds
A debt instrument issued by a company is called a corporate bond and one issued by the government is called sovereign bond. Investors can either directly buy these bonds from companies/government or, as most retail investors prefer, they can invest in these bonds through mutual fund investments.
Where do debt mutual funds invest?
- Debt funds invest the pooled capital in bonds issued by corporates, government, banks, PSUs, and PFIs (Public Financial Institutions). Most of these bonds are medium to long term. With this investment, the fund earns periodic interest payment that contribute towards the returns generated by the fund over time.
- Some funds may invest a portion of the pooled funds in money market instruments such as Commercial Papers, Certificates of Deposits, T-bills that are issued by the Government, bankers’ acceptance, bills of exchange, etc. These are short-term instruments that promise to pay fixed interest at regular intervals, thereby contributing to the returns generated by the fund.
Understanding the sources of returns for debt mutual funds
When an investor invests in a debt fund, he/she is essentially lending the money to a corporate or government entity to earn in two different ways, which are:
Interest payments
An investor earns a periodic fixed interest through a debt fund investment.
Capital appreciation
Debt instruments, such as corporate bonds, can be traded. Therefore, the value of these can change depending on the market demand and supply. For instance, a debt mutual fund invests its pooled funds in a corporate bond ‘A’ that offers an annual interest rate of 12%. If another corporate bond ‘B’ in the market is offering a lower interest rate at 8%, the value and demand of ‘A’ will increase. Thus, the Net Asset Value of the mutual fund that is invested in bond ‘A’ will also rise.
How does a debt mutual fund pick its investments?
Every bond issued in the market is required to have a rating that is disclosed to the investors. A credit rating is an indicator of the issuing entity’s reliability with regard to debt repayment. The higher the credit rating, the more likely the entity is to make timely payments. Thus, debt fund managers, depending on the fund’s objective, strategically select debt instruments that are highly rated.
Conclusion
While debt mutual funds may carry lower risk when compared to equity funds, their investments, that is, bonds and money market instruments, may fail to make timely repayments in case of financial distress. Hence, debt funds, too, carry some amount of risk. Therefore, investors must pick a debt fund that is best suited to their risk-taking ability after closing considering the fund’s investment avenues and their credit ratings.
FAQs
Debt funds are ideal for investors with lower risk appetite, since these generally diversify the investment across different securities to maintain stable returns. Although these do not guarantee returns, investors can know the approximate range of returns.
Some of the debt fund categories include liquid funds, money market funds, corporate bond funds, banking and PSU funds, gilt funds, dynamic bond funds, overnight funds, ultra short duration funds, etc.
Some of the common risks that are observed in debt mutual fund investments are credit risk, interest rate risk, and liquidity risk.
A bank FD offers a predetermined rate of return, whereas a debt mutual fund returns may change demand and supply of the debt instruments in which the fund has invested. Also, debt mutual funds may come with higher returns as compared to bank FDs.
Most debt mutual funds are ideal for short to medium term investments. For long-term investments, equity funds tend to offer better returns.
