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How do debt funds work?

Mridul Agrawal

Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market instruments and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest. Gilt fund, monthly income plans (MIPs), short term plans (STPs), liquid funds, and fixed maturity plans (FMPs) are some of the investment options in debt funds. Apart from these categories, debt funds include various funds investing in short term, medium term and long term bonds.

Debt funds are preferred by individuals who are not willing to invest in a highly volatile equity market. A debt fund provides a steady but low income relative to equity. It is comparatively less volatile.

Key benefits of debt mutual funds are-

1. Your investments are not affected by equity market volatility

2. Add stability to your investment portfolio

3. Freedom to withdraw your money when required

4. You can aim for better post tax returns.

Kavita Soni

Debt mutual funds are funds which lend you money for investments. They lend money to government, businesses and financial institutions. Returns are obtained as interest on these lendings. Government needs to borrow for investments and in exchange of borrowings it issues bonds and treasury bills. Bonds are issued for borrowings of longer duration while treasury bills are issued for a year or less. Businesses borrow for expansion purposes and they issue corporate bonds (long-term) and commercial papers (short-term). Financial institutions borrow for enhanced activities and they issue certificate of deposit and debentures.

Now let us look at how each type of funds work.

Bonds are issued by the borrowers as a certificate of deposit. Government or businesses both can issue bonds. Bonds are tradable in like shares in the market. Bonds have prices associated with them which many rise or fall based on the market conditions. Mutual funds can buy bonds. If the price of a bond rises in the market, then investors earn more income on top of the interest income from bonds. So it indirectly results into higher returns for investors.

When you buy T-bills, you essentially lend money to the government. T-bills are sold at a discounted price. After a specified maturity date, the government pays you the full price of the bill plus the earnings from investment.

Commercial papers are short-term unsecured loans issued by companies in exchange to the borrowings it did for short term financing. Commercial papers are also sold at discounts. Maturity period is very less.

Certificate of deposits are a kind of time deposits. You can buy and invest in certificate of deposits for a short time or a long time. Returns from certificate of deposits depend on the interest rate.

Debenture is a type of debt fund which are not secured by collaterals. They also can be traded in secondary markets. Again the return amount depends on the interest rate.

So, considering these explanation, you can conclude that all types of debt funds work in a similar manner and carry lower risks as compared to other funds.

Arpit Chandak

Debt funds are the types of mutual funds which invest capital of investors in bonds and deposits of various kinds and pass on the interest earned in the form of returns to the investors. In simple terms, investors lend money and earn interest (returns) on the money they have lent.

A bond is a certificate of deposit that is issued by the borrower to the lender. The process is similar to something which individual investors do when they invest in fixed deposits or FDs in banks. This is exactly the debt funds do, except there are few factors which differentiate them from others. Mutual funds invest in many types of bonds. Debt fund portfolio can comprises of various government bonds, corporate bonds, etc. Mutual funds also invest in bonds of many medium and large size businesses.

Usually, debt funds are suggested as short to medium term investment options. Unlike FDs, mutual funds invest in bonds that are tradable, just like shares in equity are tradable. There is a debt market where debt bonds are traded. In this debt market, the price of bonds can rise or fall. If a mutual fund buys a debt fund and its price rises, then it can make additional money to the investors other than interest.

Before investing in a debt fund, there are few taxation rules which investors should be aware about. It is important as an investor to know the minimum term period for long term gains so as to take advantage of lower tax on long term gains. One of the other tax benefits of the debt fund is that there is no TDS (Tax Deduction at Source) applied for returns from debt funds. A debt fund is a very liquid fund i.e. you can withdraw your money within a single day. But some debt funds charge a fine called exit load on withdrawals before maturity period. The exit load can differ from 0.5% to 2%

Advantages of debt funds are low cost structure, stable returns, high returns and they score high on safety. They are less volatile and hence less risky than equity funds. Investment in debt funds is ideal for investors who want regular income and risk averse. Therefore, debt funds can be a great medium for investors to achieve their financial goals if they do not want to bear the equity risk

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