What are debt funds?

Do you recall debt funds which we mentioned in ‘Different types of mutual funds’? Moving forward, in this article, we will focus on debt funds and their features, such as - their dissimilarities with equity funds, types, investment procedure, the effects of interest rate and most importantly - should you invest in them?

Let's start with a brief description of debt funds.

The Basics: What Are Debt Funds?

Debt funds pool money from their investors and invest it in fixed income securities, such as - corporate bonds, government securities, treasury bills, money market instruments and other such debt securities. When one invests in a debt fund, one loans his/her investments to the issuing entity. Government or private companies can issue bills and bond to get loans from the investors. They issue bills and bonds to fund their operations and grow their entity.

The interest that is earned is pre-decided along with the maturity span. Knowing this, we can easily figure out why these funds are called ‘fixed-income’ securities. Debt funds are safer than equity funds since the guarantor is usually the government, and the returns are fixed.

Dissimilarities from the equity funds

• While buying an equity fund, an individual or a group of people take part in the ownership of the company whereas in debt funds the money is loaned by the government or companies.
• Equity funds hold a much higher risk than debt funds. You cannot guarantee returns from equity funds, but the interest rates of debt funds are pre-decided.
• Equity funds have no maturity date; an investor can pull out from the investments anytime he/she wants. But, in case of debt funds, the maturity date is fixed and the investor is not allowed to pull out his/her investments.
• Debt funds offer lower returns than equity funds but, debt funds are much safer than equity funds.

Effect of interest rates

Interest rates are the repo rates which are issued by the Reserve Bank of India. The prices of the fixed income securities is inversely proportional to interest rates. Increase in interest rates reduces the bond yields and vice-versa. So, an investor must look forward to investing in debt funds when the interest rate is about to fall.

Types of debt funds

Types of debts funds in which you can invest:

• Liquid funds: These funds provide an investor with high liquidity.These funds can have maturity period as less as a day. The purpose of these funds is to earn the money market rate.
• Floating rate funds: These funds primarily invest money in floating rate debt securities. The interest earned changes in scenario with the debt market.
• Dynamic bond funds: As the name suggests, dynamic bond funds do not have any fixed maturity period. They invest money in instruments which have longer as well as shorter maturity period. So these funds have an average maturity period.
• Short-term and ultra short-term debt funds: These funds invest money in instruments which have short or very short maturity period. They generally vary from 1 year to 3 years. These are ideal for conservative investors as its interest rate is not affected by interest rate movements.
• Gilt funds: These funds invest money in government securities with medium to long term maturities. These funds are generally issued by a state or the central government.
• Income funds: Income funds invest money in corporate bonds. They are highly vulnerable to the changing interest rates. One should be interested in these funds if one is up for long term investment and high risk.

Should you invest in Debt Funds?

By now, the fact that debt funds have a lot lesser risk than equity funds should be obvious. So, if you’re a conservative investor who doesn't want to risk dabbling in equity funds; debt funds are perfectly ideal for you. They are also more tax-efficient, as well as more liquid in comparison to fixed-deposits.