What are Debt Mutual Funds and How Do They Work?

Mutual funds allow small investors to invest in a variety of financial instruments to earn good returns and create wealth. Investors have the option to start investing with very small amounts and that too without carrying out any kind of research. A variety of mutual fund schemes including equity, debt, hybrid, exchange-traded and tax saving plans are on offer to satiate the investment goals and risk profile of different investors. Here we talk about what is a debt mutual fund and how does it work?

Debt Mutual Funds and Types

The answer to what is a debt mutual fund is simple. A debt mutual fund is a fund that invests in debt instruments like fixed-income securities, debentures, corporate bonds, and money-market instruments. These types of mutual funds can help in generating wealth over the long term. Debt funds can be of several types depending on the types of instruments in which they invest and their maturity periods.

• Overnight Funds– These funds invest in 1-day maturity security papers.
• Liquid Funds– These funds invest in debt instruments having a maturity period of not more than 91 days and so are highly liquid.
• Short-Term or Medium Term or Long-Term Funds– The short-term funds invest in instruments having a maturity period of 1-3 years, medium-term in instruments with a maturity of 3-5 years, and long-term in instruments with a maturity of more than 5 years.
• Floating Rate Funds– These funds invest in instruments with a floating interest rate.
• Dynamic Funds-These funds invest in debt instruments of varying maturities.
• Credit Risk Funds– These funds invest in corporate bonds that do not have the highest ratings.

How Do Debt Funds Work?

Debt funds aim to generate stable returns by investing money in fixed-income securities and instruments and earning interest income. The yield of a debt scheme is determined by its interest income and the expenses incurred to manage it.  

A major factor impacting the performance of these funds is the interest rate changes. A rise in interest rates can have a positive impact on the yield or the interest income from the debt instrument but a negative impact on the prices of the bonds. The reverse happens when interest rates fall. The interest rate risk is more in the case of medium and long-term funds as compared to short-duration funds.

Features of Debt Mutual Funds

• Return-They offer stable returns and have the potential to offer capital appreciation over time. The returns are, however, subject to market and interest rate risks.
• Taxation- Investments in debt funds attract taxes only in the year in which they are redeemed and not before that.
• Liquidity– Debt funds do not have a lock-in period but an exit charge may be levied on an early withdrawal.
• Stability- Debt funds help you diversify your investment portfolio and balance the risk associated with an investment in equity funds.

How to Invest in Debt Funds?

Debt funds are highly suitable for investors having a moderate risk appetite. Investors can invest in these funds through the lump sum route or the Systematic Investment Plan or SIP option. The latter option allows investors to invest a small amount at regular intervals thereby encouraging disciplined investing. Investors can use the SIP investment calculator to calculate returns on their investment and choose the appropriate SIP amount.

Since a SIP helps in the creation of wealth over the long run it is suitable for investment in debt funds with long investment horizons.