How Debt Funds Work?

How Debt Funds Work?

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Understand the workings of a debt fund to make an informed investment decision

TLDR Points

  • Debt mutual fund portfolios comprise fixed-income, low-risk securities like bonds, certificates of deposit, treasury bills, commercial paper, and similar debt and money market instruments.
  • A corporate or government entity can issue a debt instrument to raise funds for their projects.

Introduction

A debt fund is a popular investment option for a diverse range of investors- retail and institutional. This article will highlight the meaning of a debt fund investment, how it works, and how to invest in debt funds.

What is a debt fund?

A debt fund invests most of its corpus in fixed-income generating instruments such as bonds, government securities, treasury bills, certificates of deposit, commercial papers, banker's acceptance, etc. These come with a fixed maturity period which can be as short as 1 day or as long as 7 years. Since the returns aren't dependent on market movements, they are considered less risky than equity funds. At the end of maturity, an investor receives their principal, interest, as well as returns or profits. The rate of interest is also pre-determined at the time of investing.

Let's see how debt funds work and what makes an investment in debt mutual funds a low-risk option.

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How do debt funds work?

When the government of India wants to start a new development project such as building ports to enhance imports, or a major corporate house needs short-term investment capital to expand its enterprise, they need liquidity. One of the options for the corporate or government entity is to borrow from a lender. This lender could be a financial institution such as a bank. If the borrower takes a loan from the bank, they will get their cash inflow, and once the loan tenure is complete, pay back the loan amount with interest. Another way the corporate or government undertaking can borrow money is by issuing bonds.

Let's see how this form of debt fund works. Assume Company A needs to raise a particular amount to fund its expansion into another city. It decides to borrow from the public instead of a bank. So, it issues a debt instrument called a corporate bond. This corporate bond is bought by retail investors as well as financial institutions such as mutual fund companies. These bonds come with a fixed maturity date and interest rate, which is determined when buying the bond. If you are a retail investor, you can invest in these bonds through mutual funds. You will earn interest as per pre-determined terms. Once the bond matures, you will receive your principal investment back.

Essentially, when you invest in a debt fund, your money is lent to a corporate or government entity to fund their undertaking, and you earn in one of two ways. Here are the two ways in which you can earn from your investment in a debt instrument:

1. Interest payments

As illustrated earlier, the investor makes a fixed interest when they invest in a debt fund.

2. Price appreciation

Another feature of debt instruments, such as corporate bonds, is that they can be traded. Their value changes as per the demand and supply in the market. For example, a debt mutual fund invests in a corporate bond with an annual interest rate of 11%. Other corporate bonds enter the market and offer a lesser rate of interest, such as 9%. This will increase the value of the former bond, and the demand for it will increase. This leads to an increase in the Net Asset Value of the mutual fund holding this bond.

You may now wonder how a mutual fund decides which debt instruments to pick. Every bond issuer, such as a corporate, has a credit rating disclosed to the public. A credit rating indicates how reliable the entity is to repay its debt. A high credit rating means that the entity is less likely to miss its payments or default. Fund managers strategically put together debt mutual fund schemes that comprise of such highly rated entities.

Lastly, to invest in a debt fund, you need to be KYC compliant and visit the AMC or fund house that manages that debt mutual fund. You can carry out the investment process online through their official website or app or visit a physical branch on their network.

Choose the debt fund best suited to you, make the payment, and enjoy the debt fund returns.

Conclusion

Equipped with this understanding of a debt mutual fund's working, you can work towards diversifying your investment portfolio.

Download digibank to create your savings account and choose from a range of debt mutual fund options to build wealth.

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