What are Debt Funds: All about Debt Funds
If you’re looking for a market-linked investment option that’s not as risky as equity but has the potential to deliver moderate returns, debt instruments may just be the one for you. One of the best ways to invest in these instruments is through debt mutual funds. They’re easy to invest in, offer much stabler returns and reduce your portfolio risk through diversification.
If you’re new to debt funds or are unaware of what they are, here’s a comprehensive guide on everything you need to know about these funds.
What are Debt Funds?
Debt funds are mutual funds that use the money pooled from investors to invest in a wide range of debt instruments of varying tenures. Some of the debt instruments that these funds invest in include corporate bonds and debentures, government bonds and money market instruments like Commercial Papers (CPs) and Certificates of Deposits (CDs).
Benefits of Investing in Debt Funds
Debt funds offer a multitude of different advantages. Let’s take a closer look at some of the key benefits of this investment option.
- Stable Returns As you now know, debt mutual funds invest in debt instruments, which are fixed-income securities. These securities provide you with a steady source of income by way of interest payments throughout the entire tenure. By investing in such funds, you can create a stable source of income which is not the case with equity funds.
- Portfolio Diversification Diversification is a technique where you invest in different investment options and asset classes to bring down risk. Debt funds enable you to achieve just that. If your portfolio primarily consists of equity instruments, investing in debt funds can help reduce risk through diversification.
- Lower Risk The returns from equity funds are heavily dependent on market performance. However, that’s not the case for debt mutual funds. Since they consist of fixed-income securities, you would get interest payments from your investments irrespective of how the market moves.
- Multiple Types Of Debt Funds One of the major advantages of debt funds is that you get the freedom to choose the kind of fund that you wish to invest in. For instance, if you wish to go by the investment horizon, you have short-term and long-term funds to choose from. Alternatively, if you wish to go by the kind of debt instruments the funds invest in, you have money market funds, gilt funds and corporate bond funds, among others.
Risks Associated with Debt Funds
Debt funds are not completely free from risk. In fact, there are four major risks that you need to factor in when investing in such a fund. Here’s a brief overview of these risks.
- Interest Rate Risk When the interest rates in the market rise, the value of bonds goes down. The interest rate risk is defined as the possibility of the interest rates rising after you invest in debt funds, leading to a fall in the Net Asset Value (NAV).
- Credit Risk Debt funds also invest in corporate bonds. The possibility of the company defaulting on its interest or principal payments is known as credit risk. Funds that invest in high-risk corporate bonds often have higher credit risk.
- Inflation Risk Inflation risk is the possibility of the returns from your debt fund being lower than the rate of inflation. Debt funds with low-yield bonds, despite being safer to invest, often have higher inflation risk.
- Liquidity Risk Liquidity risk is the possibility of not being able to sell the units of the debt mutual fund in the market. Debt funds that invest in high-risk bonds and unlisted and illiquid debt instruments have higher liquidity risk.
How to Choose The Right Debt Fund?
With so many debt mutual funds in the market, it is important to choose the right fund to invest in. Here are a few factors that you can consider when evaluating debt funds.
- Risk Tolerance The ability to tolerate risk varies from one investor to another. Therefore, it is one of the primary factors you need to consider when selecting a debt fund. The credit and risk profile of the fund should always match your risk tolerance.
For instance, if your risk tolerance levels are low, consider investing in gilt funds since they don’t have any credit risk. Alternatively, if you have a high-risk tolerance, you may choose to invest in credit opportunities funds. These funds invest in lower-rated debt instruments but offer higher returns. - Investment Horizon The period of investment is another major factor that you need to consider. You should always invest in a debt fund with tenures that match the number of years you wish to stay invested. For instance, if you don’t plan on holding your investments for more than a year, short-term debt mutual funds like money market funds may be what you’re looking for. On the other hand, if you’re willing to stay invested for a few years, you may consider investing in long-term debt funds.
- Interest Rate Expectations How you expect the interest rates to fare in the future should also be taken into consideration when evaluating a debt fund. If you expect the interest rates to rise in the future, you may want to invest in short-term or liquid funds. Alternatively, if you expect the interest rates to fall, investing in long-term funds may be the right way to go.
Conclusion
With this, you must now be aware of what debt funds are and their benefits and risks. Investing in debt funds is a great way to get stable and consistent returns. However, you should keep in mind that the returns are not always guaranteed.
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