What are Debt Funds?

A debt fund is a mutual fund that invests in debt instruments. There are different types of debt funds to suit investors with varying risk-return profiles, investment horizons, and financial goals. Debt funds invest in all kinds of debt, such as treasury-bills, government securities, commercial paper, certificates of deposits, money market instruments, securitized debt, and corporate bonds.

The key difference between a debt fund and an equity fund is that they invest in different asset classes. Equity funds invest 65% or more of their assets into equity and equity-linked products, while debt funds hold mainly bonds and cash assets. Remember that the value of an investment depends on the prices of the securities that make up the investment. Since bond prices tend to be less volatile than stock prices, debt fund values are more stable than the value of equity funds. In other words, debt funds are considered to be less risky, especially when held for short periods of time.

Debt funds offer many benefits, especially to retail investors, or to investors who have traditionally kept their money in bank deposits.

• Access to Professional Expertise and Market Returns:

  Investing in a debt fund offers the opportunity to earn interest as well capital gains from debt. It allows retail investors to access money markets or wholesale debt markets- segments in which they cannot directly invest.

• Lowers Portfolio Risk:

  Since debt funds are less risky than equity funds, a strategic allocation to the best performing debt funds reduces risk and brings stability to an investment portfolio. Tactical investments in debt funds are useful to take advantage of temporary yield opportunities.

• Range of investment options:

  Debt funds are available along the entire spectrum of maturity and credit risk. Shorter duration funds generate regular and stable income. Longer duration funds earn from interest income as well as capital gains, and suit investors who can take on higher NAV volatility. Overnight funds, liquid funds, corporate bond funds and low duration funds tend to invest in the safest debt products. Ultra-short and short duration funds may be structured to take on credit risk to provide higher returns.

• Liquidity:

  Debt funds are very liquid, and can be redeemed easily, usually within one or two working days of placing the redemption request. Unlike bank fixed deposits or recurring deposits, there is no lock-in period. While a few funds may impose a small exit load for early withdrawal, in general, there are no penalties when a mutual fund investment is withdrawn.

• Low Cost Investment:

  According the SEBI norms, the total expense ratio of a debt fund cannot exceed 2% of Assets under Management. Among debt funds, overnight and liquid funds have very low expense ratios, while dynamic and long-term funds charge higher expense ratios.

• Debt funds are mutual funds that invest in debt securities.
• There are many types of debt funds that invest across the maturity and credit risk spectrum.
• Debt funds earn accrual income from coupons and capital gains/losses as NAV is marked up or down due to changing market yields.
• How much a fund earns from interest and how much from capital gains depends on the type of bonds in its portfolio.
• Funds with lower average maturity or duration earn mainly from interest payments. Funds with a longer average maturity earn from interest coupons as well as capital gains.
• Funds can invest in lower rated debt to push up yields, but that also increases credit risk. They can increase average maturity by increasing holdings of long-term debt, but that increases the interest rate risk.
• Debt funds offer a low-cost and convenient method of taking debt exposure. They offer several advantages over traditional bank deposits as well as direct bond investment.
• Debt funds bring stability to an investment portfolio. They are useful for investors seeking regular and steady income, to facilitate goal-based financial planning and to earn alphas from interest rate changes.