Many investors are familiar with the key ideas compared to Equity Funds and how these investments operate. The same cannot be said for Debt Funds, and understanding the main concepts of Debt Fund Investing could go a long way toward ensuring that you get the most out of these investments.
A debt mutual fund invests in various debt securities, including treasury bills, corporate bonds, government securities (G-Secs), and other money market instruments with varying maturities. Debt funds are much less volatile and thus riskier than equity funds. Debt mutual funds strive to provide investors with capital preservation and consistent income. Debt funds are available in various types and categories to meet the needs of investors with varying time horizons and liquidity preferences.
What is debt mutual funds?
They are mutual funds that invest in fixed-income securities such as Commercial Papers (CP), Certificates of Deposit (CD), Corporate Bonds, government securities, T-Bills, and other money market instruments. Debt Funds have a fixed maturity date and an interest rate that buyers can earn until the security matures. They are considered less volatile than equity funds and are ideal for risk-averse investors who seek stability in their investments.
What are the different types of debt instruments?
Certificates of Deposit (CD): Short-term deposits with banks that last up to one year and financial institutions that last up to three years.
Treasury Bills (T-bills): Short-term securities issued by the Indian government with less than one-year maturities.
Corporate Bonds: Long-term corporate borrowings with maturities of more than one year.
Government Bonds: Long-term borrowings by the state or federal government with one year or more maturities.
Tri-Party Repo: An instrument for borrowing funds through the sale of securities with an agreement to buy back the securities at a mutually agreed-upon future date at an agreed-upon price that includes interest for the funds borrowed.
Commercial Paper (CP): Short-term borrowings of up to one year by corporations and financial institutions.
Benefits of investing in debt funds
- These debt funds provide a hedge against stock market risk. Debt funds, in general, are said to be less risky than stocks. This is because fixed-income assets are less sensitive to macro risks such as economic downturns, sectoral downturns, and geopolitical events. When stocks fall, these debt fund investments can help offset some equity losses.
- Second, debt funds are the best way to maintain capital. What does this imply? Capital preservation entails safeguarding the absolute value of the investment through assets with a stated goal of principal return. Because fixed income typically carries less risk, these assets can be a good option for investors who do not have much time to recover losses.
- They also provide crucial regular income generation. Fixed income funds can assist you in generating a consistent source of income. Investors receive the amount of income at regular intervals in the form of bond fund dividends.
- Even debt funds provide return enhancement with a higher degree of risk, increasing total returns. Some fixed-income assets have the potential to produce attractive returns. Investors can increase their returns by taking on even more credit risk or interest rate risk. This is a popular strategy employed by debt funds.
Are there risks associated with debt funds?
- The interest rate risk is the most crucial of these. Bond prices come down once interest rates rise, implying that the bonds you own lose value. Changes in interest rates primarily cause bond market price volatility.
- Inflation risk is the risk that the rupee will lose value due to price increases. Bond investors must also be concerned about inflation. Bonds pay out fixed returns at set intervals. However, if the inflation rate exceeds the fixed amount of income, this same investor loses purchasing power. This is measured in terms of real returns.
- The debt issuer’s risk of default is referred to as credit risk. In India, we’ve seen this quite frequently. When you buy corporate bonds, you are taking on credit risk and interest rate risk. The possibility of the issuer defaulting on debt obligations is referred to as credit risk (also identified as business risk or financial risk). If this occurs, the investor may not receive the full amount of their initial investment. It’s more pronounced in smaller businesses.
- Last but not least, there is also the issue of liquidity. This is the likelihood that the investor wishes to sell a fixed-income asset but cannot find a buyer. When the fund invests in unlisted securities, it may face liquidity risk.
Debt mutual funds are an option worth considering if you want relatively stable incomes to equities and limited exposure to market risk. You can invest in various debt funds, including liquid funds, fixed maturity plans, ultra-short-term debt funds, and many others, based on your investment objectives and time horizon.