Puzzled about debt funds? Here are answers to six common questions

If you are looking for fixed income financial instruments to add to your portfolio, then debt funds are the most eye-catching choice. 

Debt funds demystified

Debts funds are like loans where you become the lender to the debt instrument issuing company. 

• Debt funds are mutual funds investments in debt instruments like corporate bonds, treasury bills, debentures, government securities, commercial papers and on various other money market debt instruments. These financial instruments generate a fixed income within a specific period of time and carry an interest rate. The lender earns the fixed income and there is a maturity period for every instrument as well. 
• The issuer of the instrument decides the rate of interest and the maturity date as well. 

Related: ​A quick guide to debt funds​​​

So, before you invest your money in debt funds, ask yourself these six questions to be clear about the investment you are going to make. 

1. How does the interest rate affect debt fund prices?

• The first thing you need to know when investing in debt funds is the relation between the interest rate and the price of the debt instrument or the debt fund.
• Interest rate changes have a huge impact on debt fund prices, especially when the maturity term is long. 
• When the interest rate increases, the price of the debt funds fall and vice versa. 
• This is due to the inverse relationship between the yield of the debt instrument and its price. When interest rates fall, the prices of the bonds go up. This increases the net asset value of the debt funds. 

2. What if the company fails to repay what you have invested in their debt funds?

• This question must have crossed your mind when thinking about debt funds since you are not investing but providing debt to the debt issuing company. 
• So, what if the company cannot repay the debt? This is called default risk and is inevitably associated with the debt funds. 
• There are lower-rated papers which have the most amount of risk associated with them but can generate great returns. 

3. How does your debt fund manager invest in debt funds?

• Your fund manager makes sure that all the investments he carries out for you in the debt fund are for companies which have higher credit ratings. 
• Higher ratings ensure that the company is likely to pay back the interest component duly along with the principal amount, on the maturity of the debt fund. 
• The volatility of the higher-rated instruments is low when compared to the lower-rated instruments. Crucial to the investment strategy is another factor that is considered by your fund manager. This is the interest environment in the economy. 
• If the interest rate is falling, then the fund manager is more likely to invest in long-term instruments and vice versa. 

4. How much returns should be expected from debt funds?

• If you are investing with the thought of accumulating a huge amount of wealth from the debt funds, then you need to reconsider your investment ideas. 
• Debt funds are primarily used for generating regular incomes, which are higher than the savings deposit or a bank FD’s income. But these are not for the accumulation of wealth like in equity-based schemes. 
• Debt funds are referred to as fixed-income instruments, which means you will earn a regular income from the interest paid by the issuing firm. 

Related: ​Investment Options That Are Popular Among Retirees​​​

5. Are there any risks associated with debt fund investments?

• Yes, there are four different kinds of risks associated with debt funds. Out of the four, we have discussed the default risk in the second question above. The other three risks are: 

a. Credit Risks: 

• If there are certain issues with the financial profile or in the administration of the issuing company which downgrades its credit rating, its NAV also decreases. 
• This is owing to the fact that when the ratings go down, the yield of the bonds go up and the bond price goes south. 

b. Market Risk: 

• This is the risk associated with any investment scheme, but with debt fund, the impact of the interest rate change is exponential as discussed above. 
• So, if the market has frequent fluctuation in the interest rate, the debt fund NAV gets affected. 
• The long-term debt funds are highly sensitive to the interest rate changes. 

c. Liquidity Risk: 

• If the debt fund becomes unsellable in the market, its liquidity goes down and so does its NAV. 
• This situation can occur from the credit crisis in the economy, decreasing demands for low-rated debt instruments and souring market sentiments.

6. How to decide whether debt funds are for you or not?

• Debt funds becoming fixed income instruments are best for the risk-averse investors who are more focused on regular income and slow but steady wealth generation. 

So, now, whenever you decide to invest in debt funds, do not forget to ask yourself these six questions. Have a look at the types of mutual funds and how to start investing in them so that you can make an informed decision about your investment portfolio.

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.