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    What Are Debt Funds?

    what are debt funds
    (Source: hindustantimes)

    Mutual funds are an ideal investment vehicle for investors who lack the know-how to invest in stocks. There are different kinds of mutual funds, one of which is debt funds. This article elaborates on what are debt funds, so that one can make an informed investment decision.

    Let’s begin!

    What Is the Meaning of Debt Funds?

    Debt funds are a type of mutual fund scheme that primarily invests in different types of fixed-income securities, such as bonds, treasury bills, etc. As a result, a debt fund offers steady and regular income to investors in the form of debt fund interest rates.

    Moreover, as they invest in fixed-income securities, the best debt funds involve less risk than their equity counterparts. That said, they also offer lower returns.

    How Do Debt Funds Work?

    Now that you know what debt funds are, let’s understand how they work – 

    A debt fund invests in a range of securities depending on their credit rating. Here, the credit rating of a security refers to the risk of default of its issuer. In simpler words, a high credit rating implies that the issuing entity of a security is more likely to pay the principal upon maturity as well as regular interests. 

    Therefore, fund managers ensure debt funds invest in instruments with a high credit rating, which are less volatile than low-rated ones. Moreover, the performance of a debt mutual fund depends on the investment strategy of its fund manager.

    In addition, an economy’s overall interest rate also impacts its performance. This implies that a falling interest rate regime allows a fund manager to invest in long-term securities. On the other hand, in a rising interest rate regime, he/she will invest in short-term securities.

    Who Should Invest in Debt Funds?

    As they invest in fixed-income securities, debt funds that are considered ideal for risk-averse investors who are looking for stable returns. Moreover, as they are less risky than other types of mutual funds, investment in a debt mutual fund can also be suitable for novice or first-time mutual fund investors.

    What Are the Different Types of Debt Funds?

    There are several debt fund types, some of which are as below:

    • Liquid Fund- This type of fund invests in debt instruments that have a maturity period of a maximum of 91 days.
    • Overnight Fund- It invests in debt instruments that have only 1 day of maturity.
    • Short Duration Fund- Short term debt funds invest in instruments with shorter maturities, which typically ranges from 1 year to 3 years. In India, Axis Short Term Fund, ICICI Prudential Short Term Fund are some of the best short term debt funds.
    • Medium Duration Fund- It invests in debt instruments that have a maturity of 3 years to 4 years.
    • Long Duration Fund- Invests in instruments that mature after a period of 7 years. Edelweiss Government Securities Fund and Nippon India Prime Debt Fund are some of the examples of best debt funds for long term.
    • Corporate Bond Fund- This fund invests a majority of its total assets in corporate bonds, especially in those with a credit rating of AA+ or above.
    • Dynamic Bond- The fund manager of a dynamic bond alters the portfolio composition on the basis of fluctuating interest rate regime.
    • Gilt Fund- It predominantly invests in low-risk and high-rated government securities or G-secs.

    What Are Debt Fund Returns?

     

    Debt fund returns are the interests that investors earn by investing in government securities, bonds, and other fixed-income instruments.

    For a clearer understanding of returns on debt funds, take a look at the past performance of the best type of debt funds in 2021 (source):

    Mutual Fund

    3-Year Returns

    5-Year Returns

    ICICI Prudential Multicap Fund

    18.17%

    13.57%

    DSP Government Securities Fund

    11.46%

    8.51%

    IDFC Government Securities Fund – Constant Maturity Plan

    11.66%

    9.69%

    Nippon India Nivesh Lakshya Fund

    11.79%

    NA

    Edelweiss Government Securities Fund

    11.35%

    8.62%

    *data as on 21 October 2021 and is subject to change.

    What Are the Different Risk Factors in Debt Funds?

    There are a number of risk factors associated with debt funds. These include the following:

    • Credit Risk- The issuer of a debt security may falter in repaying the principal or making regular interest payments.
    • Interest Rate Risk- The price of fixed-income securities is inversely related to changes in interest rates. This implies that when the interest rate increases, prices go down and vice versa.
    • Liquidity Risk- It refers to a situation wherein an investor may find it difficult to redeem a debt fund investment without incurring a loss. Such a circumstance arises when a seller cannot find a buyer for his/her security.

    Points to Consider Before Investing in Debt Funds

    There are certain factors investors must keep in mind while investing in debt funds. These include -

    • Risk Appetite: All mutual fund investments involve risks to some extent. As afore-mentioned, debt funds are exposed to interest rate risk, credit rate risk, and liquidity risk. Hence, investors must weigh their risk appetite before investing in a debt mutual fund.
    • Expense Ratio: Like any other mutual fund scheme, debt funds come with an expense ratio, which is a fee levied by fund houses for their services. Moreover, this fee increases the cost of an investment and varies with different mutual fund schemes. Therefore, before investing in a debt fund, investors must check its expense ratio.
    • Investment Horizon: Before investing in mutual funds, one must determine the tenure for which he/she can remain invested in a scheme. An investment horizon of 3 to 12 months is considered ideal for debt mutual funds. 
    • Financial Goals:  When investing in debt mutual funds, one must evaluate his/her investment goals. Moreover, investors should ensure that their choice of debt fund scheme aligns with their short- or long-term financial goals.


    On that note, we have reached the end of this article on what are debt funds. We hope that you now have a clearer understanding of debt mutual funds, their types, risk factors, and benefits. Additionally, remember to take the above-mentioned factors before investing.

    Frequently Asked Questions

    Does a gilt debt fund carry any credit risk?

    Gilt debt funds carry minimal credit risk as they primarily invest in government securities.

    Gilt debt funds carry minimal credit risk as they primarily invest in government securities.

    Are overnight debt funds safe?

    Yes, overnight funds are usually safe as there are minimum interest risks and credit risks.

    Yes, overnight funds are usually safe as there are minimum interest risks and credit risks.

    What is the best debt fund for 1 year?

    Low duration fund is the best debt fund for 1 year.

    Low duration fund is the best debt fund for 1 year.

    What is the best debt fund for 3 years?

    Short duration fund is the best debt fund for 3 years.

    Short duration fund is the best debt fund for 3 years.

    How to invest in debt funds?

    Investors can invest in debt funds using two methods, namely lumpsum investment and a systematic investment plan (SIP).

    Investors can invest in debt funds using two methods, namely lumpsum investment and a systematic investment plan (SIP).

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    Last updated: 2023-01-30

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