All About Debt Funds

Introduction

 

Hey! The financial world has changed. And with it has changed the money management techniques. Earlier people used to put their money in fixed deposits or in bank lockers on a certain interest rate. But nowadays the investment field has expanded. New doors have opened up and new methods have come in place of the old ones. 

 

Even debt has its own method of raising money in today’s world. People use debt instruments in order to raise money. When businesses or entities that issue debt instruments need money, they 'borrow' from investors. In exchange, they guarantee a steady and consistent rate of interest. In simple terms, this is how debt instruments function.

 

One of these debt instruments is the Debt Fund.

 

In this blog, we are going to talk about these debt funds only. So, let’s dive in.

 

What are Debt Funds?

 

Purchasing a debt instrument might be viewed as a loan to the entity that issued the instrument. A debt fund invests in fixed-income securities such as corporate bonds, government securities, treasury bills, commercial paper, and other money market instruments in order to generate interest. 

 

Also Read | 4 Types of Bonds

 

The primary rationale for investing in debt funds is to obtain a consistent interest income as well as capital growth. Debt instrument issuers pre-determine the interest rate and maturity period you will receive. As a result, they're also referred to as 'fixed-income' securities.

 

Debt funds are great for investors who want a steady stream of income but don't want to take any risks. Debt funds are less riskier than equities funds since they are less volatile. 

 

Debt Mutual Funds may be a better alternative if you have been investing in traditional fixed income products like Bank Deposits and are looking for regular returns with little volatility, since they help you achieve your financial goals in a more tax efficient manner and hence earn greater returns.

 

How do Debt Funds Work?

 

Debt funds invest in a wide range of assets based on their credit ratings. The credit rating of a security indicates the likelihood of the debt instrument issuer failing to deliver the promised returns. 

 

A debt fund manager ensures that he invests in credit instruments with a good credit rating. A better credit rating indicates that the organisation is more likely to pay both interest and principal on the debt security on a regular basis.

 

When compared to low-rated securities, debt funds that invest in higher-rated securities are less volatile. In addition, maturity is influenced by the fund manager's investment strategy as well as the economy's overall interest rate regime. The fund management is encouraged to invest in long-term securities by declining interest rates. A rising interest rate environment, on the other hand, stimulates him to invest in short-term securities.

 

Types of Debt Funds

 

There are different types of debt funds. They are:

 

1. Liquid Funds

 

Liquid funds, as the name implies, are a sort of debt mutual fund that is extremely liquid. These funds invest in debt assets that have a maximum maturity of 91 days. Some liquid funds allow investors to withdraw up to Rs.50,000 as a rapid redemption facility. These mutual funds are thought to be among the safest in the industry.

 

2. Short / Medium / Long Term funds

 

Short-term debt funds have a one- to three-year maturity horizon. These funds are suited for investors with a low risk appetite since interest rate risk, also known as interest rate risk, has little impact on their values.

 

Long term funds have a portfolio age of more than 5 years, whereas medium term funds have a portfolio maturity of 3-5 years. 

 

Short-term funds are riskier than medium- and long-term funds, owing to the fact that the longer the tenure, the greater the influence of interest rates on the portfolio. This is also known as interest rate risk or duration risk.

 

3. Dynamic Bond Funds

 

In dynamic bond funds, the fund manager adjusts the portfolio's maturity based on their interest rate estimate. The maturity is shorter if interest rates are expected to rise. The maturity is longer if interest rates are expected to fall. The maturity term for these funds is variable. They invest in products with short maturities (1-3 years) as well as longer maturities (3-5 years). These funds carry a minor risk premium over short-term debt funds.

 

4. Fixed Maturity Plans

 

FMPs (Fixed Maturity Plans) have a lock-in term. Depending on the scheme you select, this time frame may vary. FMPs can only be purchased during the original offer period. After then, you won't be able to invest in this scheme again. Because both come with a lock-in term, many investors compare FMPs to FDs. FMPs, unlike FDs, do not guarantee fixed returns. FMPs, on the other hand, are more tax efficient than FDs.

 

5. Income Funds

 

Income funds make interest rate decisions and invest mostly in debt assets with long maturities. As a result, they are more reliable than dynamic bond funds. Income funds have an average maturity of five to six years.

 

6. Gilt Funds

 

Gilt Funds only invest in government securities, which are highly rated and have a low credit risk. Because the government rarely defaults on the debt instruments it issues, gilt funds are an excellent choice for risk-averse fixed-income investors.

 

7.  Credit Opportunities Funds

 

These are some of the more recent debt funds. Credit opportunities funds, unlike other debt funds, do not invest according to the maturity of debt instruments. These funds strive to outperform the market by taking credit risks or investing in lower-rated bonds with higher interest rates. Credit opportunities funds are a type of debt fund that is more risky.

 

How to Invest in Debt Funds?

 

In general, there are two ways to invest in a debt fund:

 

• Investing in a lump sum

• Systematic Investment Plan(SIP)

 

The lump sum technique is preferred if you have a significant amount of money to invest all at once. This is an appropriate alternative if you have a large sum of money. You must, however, select a fund type based on your investing timeframe or aim.

 

A Systematic Investment Plan (SIP) is a good option if you want to invest small amounts of money at regular periods. To determine returns on your investment, use the SIP calculator. 

 

This is better suited to employees who are paid on a monthly basis. Investing with a systematic investment plan (SIP) improves your investment discipline while lowering your risk by allowing you to acquire more units when prices are low and fewer units when prices are high.

 

Also Read | Mutual Funds in India: An Overview

 

How to Choose a Debt Fund?

 

There are numerous debt funds from which to pick. Choosing the correct fund from a variety of possibilities might be difficult. So, before you choose a fund, examine the following aspects.

 

The goal of the investment

 

Ask yourself, "What is my investment objective?" before choosing a debt fund. Do you want to build an emergency fund? Different types of debt funds cater to different investment purposes, as we've seen above. As a result, after you've determined your investing goal, choosing the correct fund becomes a lot easier.

 

Time Horizon

 

Every investment objective has a time restriction. Liquid funds are recommended if you have a short-term investment goal of 3 months to a year. You can use short-term debt funds if the period is between 1-3 years. Dynamic / medium term bond funds, on the other hand, are better suited to investors with a 3-5 year time horizon.

 

Risk

 

Debt funds are more risky than bank FDs since they are subject to credit risk and interest rate risk. In credit risk, the fund manager may invest in securities with a low credit rating and a higher chance of default. Bond prices may fall due to an increase in interest rates in interest rate risk.

 

Conclusion

 

Debt mutual funds are a good alternative to consider if you want a more consistent income than stocks while also limiting your exposure to market risk. You can invest in a variety of debt funds, including liquid funds, ultra-short-term debt funds, fixed maturity plans, and more, depending on your investing objectives and time horizon.