All You Need to Know About Debt Funds

Savings have always been an important aspect of every individual’s life irrespective of whether he/she is a homemaker, a student, an employed person, or owns a business. Earlier, the term “savings” itself meant having a fixed deposit with the bank. This would have been a wise option years ago when the interest offered was quite high. However, these days, with the interest rates seeing a decline, there is a wide range of investment options that offer safety, good returns, diversification, minimize risks, and also offer tax benefits. One such product that is quite popular is the debt mutual fund. So, let’s get to know more about a debt mutual fund, right from the basics!

Debt Fund – Meaning

A debt fund is a mutual fund that will invest your funds in fixed income securities & money market instruments that are issued by numerous institutions, and the government. It is also known as a fixed-income fund. A debt fund aims at generating stable returns. So where does a debt fund invest in? It invests in corporate market instruments like PSU bonds, corporate bonds, debentures; money market instruments like Repos, Commercial Papers, Certificates of Deposits, and Gilts like government securities, treasury bills, state development loans, and the like. 

Debt Fund – Why Should One invest in It?

Investing in a Debt fund can be beneficial in the following ways:

  1. Debt funds help in portfolio diversification and help an investor achieve their long-term goals by acting as a cushion to the downside risk of their portfolio.
  2. Debt funds offer liquidity, i.e., an investor can withdraw their investment at any point of time and the amount gets credited to their account the following day. However, note that a few debt funds could charge exit loads.
  3. Though a debt fund might not offer assured returns that a Bank FD offers, the volatility in returns is limited to low-moderate. 
  4. A debt fund earns in two ways – capital appreciation and accrued interest.
  5. If an investor holds a debt fund for more than 3 years, then the benefit of indexation helps the investor earn much better post-tax returns.
  6. An investor can invest in a Debt fund either by Systematic Investment Plan (SIP) or by Systematic Transfer Plan (STP), or Systematic Withdrawal Plan (SWP)  based on their investment goals. This makes a debt fund very flexible and a convenient investment option.

Debt Fund – The Risks

Along with the benefits, a debt fund also comes with a few risks. They are:

1. Interest Rate Risk:

There is no guarantee of the stability of interest rates. There could be a rise or even a decline in the rates, and this has an impact on the returns of a debt fund. You must know that the movement of the NAV and interest rates are always in the opposite direction. Also, the fluctuation of NAV is much more for funds with longer maturity than that with a shorter maturity.

2. Liquidity Risk:

When faced with adversities in the market, selling off investments and redeeming units might seem tough due to a fall in the volumes. This is known as liquidity risk.

3. Credit Risk:

When an issuer doesn’t pay off the maturity proceeds and coupon income with the dates specified, it leads to erosion of capital, due to the fall in credit rating. This is known as credit risk. Note that government-issued securities do not have credit risk.

Debt Fund – How does it work?

Now that the benefits and risks of investing in a debt fund are pretty much clear, let’s understand how a debt fund actually works. So, there are two important strategies followed by a debt fund to generate returns. They are:

1. Accrual Strategy

Under this strategy, the aim of the fund is to derive returns by reducing the interest rate risk and managing the credit risk as well. This strategy is mainly followed by funds with shorter maturity periods. The securities will be held till the maturity period under the accrual method and the focus is on interest income.

2. Duration Strategy

This strategy focuses on a capital appreciation that takes place when there is a rise in the price of the bond because of a fall in interest rates. It doesn’t focus on Interest income. The aim is to generate returns by investing in debt instruments with a longer maturity, thereby managing interest rate risk. Gilt Funds and longer-duration funds usually follow the duration strategy.

We get it that investing in any type of financial instrument, be it equities or debt funds requires a little bit of know-how about them, and researching can be quite a task! Hope this article gives you an idea about debt funds, their benefits, and risks, and helps you in your decision-making process.