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!

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.

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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.

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Highlighted below are some of the benefits of a debt mutual fund:

• Reduced Risk: Debt funds carry lower risk as these funds are not affected by market fluctuations. As a result, these funds are less volatile than other market-linked investment instruments. 

• Higher Stability: As debt funds invest in fixed-income securities, they generate predictable and stable returns. This aspect of debt funds makes them an ideal investment instrument for risk-averse investors. 

• High Liquidity: Investing in Debt funds allow investors to enjoy high liquidity. As a result, investors can quickly cash out their investments as compared to other investment instruments.

• Debt Fund Indexation Benefits: Debt funds come with indexation benefits. This implies that investors can adjust the purchase price of their investments so that the effect of inflation is reflected on them. 

With the help of indexation, one can reduce his/her long-term capital gains, which reduces the taxable income. In this regard, prospective debt fund investors must also note that these mutual fund schemes do not attract TDS, which makes them tax-efficient investment instruments.

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.

Investors willing to invest in Debt funds can follow any of the two investment ways mentioned below.

• Lump sum Investment - In this method, individuals who have surplus money and want to invest in one go can opt for lump sum investment.
• Systematic Investment Plan (SIP) -  Individuals who want to invest smaller portions at regular intervals can choose Systematic Investment Plan as their ideal investment method for 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.

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.