Debt Fund

Updated on January 5, 2024
Article byAswathi Jayachandran
Edited byAlfina
Reviewed byDheeraj Vaidya, CFA, FRM

What is Debt Fund?

Debt fund are investments, such as a mutual fund, closed-end fund, ETF, or unit investment trust (UTI), that primarily invest in fixed-income instruments like bonds or other types of a debt security for returns. These investments can include government bonds, corporate bonds, municipal bonds, etc.

They are otherwise known as bond funds or income funds. The prime objective of such instruments is to give consistent returns in the form of interest payments. They are popular options for investors with a low-risk appetite. It aids in the diversification of a portfolio and protects the stock market’s volatilities.

Key Takeaways

  • A debt fund is an investment using fixed income securities such as T-bills, commercial papers, debentures, G-secs, corporate bonds, and other money market instruments.
  • The main goal is to earn money through interest payments. They also protect investor portfolios from market volatility.
  • These are preferred over equity funds regarding risk, stable returns, and transaction costs.
  • They are similar to any other investment and come with credit risk, interest rate risk, and prepayment risk, which investors should be cautious of.

Debt Fund Explained

Debt Funds

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Debt funds invest in fixed-interest generating securities such as commercial papersCommercial PapersCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note.read more, corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more, debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more, government securities (G-Secs), Treasury billsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more, and other money market instruments. It is termed so because the issuers of the instruments borrow money from lenders.

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The main goal of these funds, or any money market instruments, is to earn money through interest payments. Some debt funds also provide investors with capital appreciation. Debt mutual funds are important additions to an investor’s portfolio as they diversify the portfolioDiversify The PortfolioPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more and protect it from stock market volatility. Debt mutual funds offer low to moderate risk and high liquidity and protect investors from the dynamics of market sentiments. When compared to bank deposits, debt fund returns have the potential to provide a better and higher rate of returns.

Investors should be aware of the credit, interest rate, and prepayment risks that debt funds come with. Credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more occurs when the issuers of the bonds fail to pay the debt they owe on the bonds issued by them. Interest rate riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more arises when interest rates go up, but the market value of bonds owned by the general fund goes down. All bonds typically carry such risks, but longer maturity bonds are more vulnerable than shorter maturity bonds. Finally, the prepayment riskPrepayment RiskPrepayment Risks refers to the risk of losing all the interest payments due on a mortgage loan or fixed income security due to early repayment of principal by the Borrower. This Risk is most relevant in Mortgage Borrowing which is normally obtained for longer periods of 15-30 years.read more is when issuers pay off the bond early. In such cases, the bond issuer may decide to pay off its debt and issue bonds with lower pay rates.

Types of Debt Fund

One can categorize the bond according to its maturity period, which is the day on which the company must repay investors their principal. Maturities can be short-term funds (less than three years), medium-term funds (four to ten years), or long-term funds (more than ten years). Longer-term bonds typically have greater interest rates, but they also come with more risks.

Given below are a few types of debt funds:

Liquid debt fund

Liquid debt funds invest in money market instruments with a short maturity period. It is an ideal short-term investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more option that provides better returns than the usual bank interest rate.

Government bond

They are debt obligations that the respective governments issue. Treasury securities include treasury bills, notes, and bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more. These debt fund returns are one of the safest as the government backs them. Investors should note that debt fund taxation in the U.S. means the income earned by treasury securities is taxable federally, even if it is exempt from state or local taxes.

Municipal Bonds

They are debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more issued by states, cities, counties, municipalities, and other governmental entities to support ongoing obligations and finance public utility projects. Debt fund taxation on Municipal bond interest is generally free from federal income tax. In addition, if the investor resides in the state where the bond was issued, the interest may be free from state or local taxes.

Corporate bonds

Investors who purchase corporate bonds are lending to the company that is issuing the bond. In exchange, the corporation agrees to pay interest on the principal and, in most cases, return the principal when the bond matures or comes due. 

Private debt funds

Another classification of funds, such as the private debt fund, focuses on lending activity handled by companies other than banks. These funds raise funds from investors before lending them to various businesses. One uses a private debt fund as an alternative to banks’ traditional lending.

Investment and non-investment grade

Bonds are also classified as investment grade or non-investment grade based on their credit ratings. Investment-grade bondsInvestment-grade BondsInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more are more likely to be paid on time than non-investment-grade debts. Non-investment grade bonds, commonly known as high-yield or speculative bonds, have higher interest rates to reward investors for taking on more risk.

In addition, bonds can differ in terms of interest payments. Interest payments are called “coupon payments,” and interest rates are called “coupon ratesCoupon RatesThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more.” A fixed coupon rate pays the same regardless of interest changes in the market rates. On the other hand, floating rates reset the bond interest rates periodically according to the changes in the market rates. They are usually determined based on a bond index or related benchmarks.

Example

David wants to invest, and he is looking at the criteria for investing in debt mutual funds. The data he analyzed is as follows:

5 Year. Returns3 Year. ReturnsMin. InvestmentRating
ABC1914$1000Not available
XYZ108$1500Good

From the data above, it is evident that there is an increasing rate of returns over a long period in the case of ABC here. But unfortunately, the rating of the fund is unavailable. This may mean that they do not possess payment credibility. In the case of XYZ, the interest rates are not much different from each other, even for a long period. However, XYZ has been rated good, meaning the company makes returns without default. This is the trustworthiness of the company, and investors can choose to put their money into a highly rated company.

Debt Fund vs Equity Fund

Equity Funds are a type of mutual fund scheme that invests their assets in stocks of various companies based on the underlying scheme’s investment objective. Both concepts are different from each other. Debt mutual funds have fewer risks than equity funds in comparison. Debt or income mutual funds invest in government and company-issued fixed income instruments. Fixed income securities include corporate bonds, money market instruments, government securities, Treasury bills, and other debt securities. Debt funds are less risky than equity mutual funds and have the potential to provide higher returns than typical bank savings accounts.

Compared to equity mutual funds, debt mutual funds are invested in fixed income instruments and provide stable and consistent returns. As a result, debt mutual funds may be an excellent way to protect investments from market volatilityVolatilityVolatility is the rate of fluctuations in the trading price of securities for a specific return. It is the shift of asset prices between a higher value and a lower value over a specific trading period. read more. These funds are less risky and volatile than other types of market-linked securities. Another factor to be considered is that when compared to equity and other Mutual funds, the debt-income fund has lower transaction costs.

Frequently Asked Questions (FAQs) 

How do debt funds work?

These funds generate returns for investors by taking the money and investing it in government bonds and other fixed-income securities. As a result, they are relatively low-risk investments.

How to invest in debt funds?

Investors can buy debt or income bonds after research and analysis. For this purpose, an investment account needs to be created, or they can take help from a financial advisor.

Are debt funds safe?

They like all securities, and investments are not risk-free. They carry risk but to a lesser degree than other instruments available in the market. These funds come with credit risk, interest rate risk, and prepayment risk, which investors should be aware of.

What are short-term debt funds?

Short-term funds refer to those income funds that are best suited for investors with a low-risk appetite. They offer a moderate maturity period of one to three years. Stable returns and medium risk accompany them.

This has been a guide to What is Debt Fund and its meaning. Here we discuss its types, examples and a comparison between Debt Fund vs Equity Fund. You can learn more from the following articles – 

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