What are Debt funds? | Meaning, Types, Benefits?

What are debt funds?

Debt funds or debt mutual funds invest in fixed income securities such as Corporate Bonds, Treasury Bills, Government Securities, Money Market instruments and other debt securities. Debt bonds have a fixed maturity time and pay a fixed rate of interest.

How do debt funds work?

Firstly, you need to understand that buying debt funds is similar to giving loan. However, here you earn interest income and capital appreciation. The interest you earn and the maturity duration are pre-decided. That is the reason why debt funds are known are ‘fixed income’ securities.

Debt funds diversify across different types of securities and thus help optimize the returns. The returns can be expected to be in a predictable range and is safe for conservative investors. The fund manager invests in high credit quality instruments which are more likely to pay interest on debt security as well as the principal amount on maturity. Interestingly, the maturity depends on the investment strategy of the fund manager as well as the interest rate in the economy. In other words, a falling interest rate will encourage the manager to invest in long-term securities while a rising rate will encourage the manager to invest in short-term securities.

How to invest in debt funds?

Debt funds are ideal for conservative investors. Debt mutual funds can be invested for short-term as well as long-term.

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Types of debt funds in India

There are various types of debt mutual funds. Have a look at some of the debt funds.

1. Dynamic bonds: In this, the fund manager keeps changing the portfolio composition according to the changing interest rates.Dynamic bonds have a fluctuating maturity period as these can be invested in both long as well as short maturities.

2. Income bonds: Income bonds are similar to dynamic bonds, in the sense that they can be invested in both long term as well as short term maturities. However, in most cases, income bonds invest in long term (average of 5-6 years) maturity securities. Income bonds are more stable than dynamic bonds.

3. Liquid funds: Liquid funds invest in debt funds having a maturity of 91 days. These funds are risk free and rarely have negative returns. Liquid funds are considered to be better option to savings bank account as they offer higher returns and similar liquidity. Interestingly, many companies offer instant redemption on liquid funds.

4. Gilt funds: Gilt Funds invest only in high rated securities such as government securities. Government securities come with low credit risks as government seldom defaults on loans it takes through debt instruments. Gilt funds are ideal for fixed income investors.

5. Short-term and ultra short term debt funds: These funds invest in instruments that have short maturities between one year and three years. These debt funds are not affected by interest rate regimes and are ideal for conservative investors.

6. Fixed maturity plans (FMP): These are closed-end debt funds. Fixed maturity plans invest in fixed income securities such as government securities and corporate bonds. Fixed maturity plans come with a lock-in period- it can either be a few months or a few years. Although FMPs can deliver high and tax efficient returns, it does not guarantee returns.