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What is Debt Fund?
Debt fund are investments, such as a mutual fund, closed-end fund, ETF, or unit investment trust (UTI), that primarily invest in fixed-income instruments like bonds or other types of a debt security for returns. These investments can include government bonds, corporate bonds, municipal bonds, etc.
They are otherwise known as bond funds or income funds. The prime objective of such instruments is to give consistent returns in the form of interest payments. They are popular options for investors with a low-risk appetite. It aids in the diversification of a portfolio and protects the stock market's volatilities.
Table of contents
- A debt fund is an investment using fixed income securities such as T-bills, commercial papers, debentures, G-secs, corporate bonds, and other money market instruments.
- The main goal is to earn money through interest payments. They also protect investor portfolios from market volatility.
- These are preferred over equity funds regarding risk, stable returns, and transaction costs.
- They are similar to any other investment and come with credit risk, interest rate risk, and prepayment risk, which investors should be cautious of.
Debt Fund Explained
Debt funds invest in fixed-interest generating securities such as commercial papers, corporate bonds, debentures, government securities (G-Secs), Treasury bills, and other money market instruments. It is termed so because the issuers of the instruments borrow money from lenders.
The main goal of these funds, or any money market instruments, is to earn money through interest payments. Some debt funds also provide investors with capital appreciation. Debt mutual funds are important additions to an investor's portfolio as they diversify the portfolio and protect it from stock market volatility. Debt mutual funds offer low to moderate risk and high liquidity and protect investors from the dynamics of market sentiments. When compared to bank deposits, debt fund returns have the potential to provide a better and higher rate of returns.
Investors should be aware of the credit, interest rate, and prepayment risks that debt funds come with. Credit risk occurs when the issuers of the bonds fail to pay the debt they owe on the bonds issued by them. Interest rate risk arises when interest rates go up, but the market value of bonds owned by the general fund goes down. All bonds typically carry such risks, but longer maturity bonds are more vulnerable than shorter maturity bonds. Finally, the prepayment risk is when issuers pay off the bond early. In such cases, the bond issuer may decide to pay off its debt and issue bonds with lower pay rates.
Types of Debt Fund
One can categorize the bond according to its maturity period, which is the day on which the company must repay investors their principal. Maturities can be short-term funds (less than three years), medium-term funds (four to ten years), or long-term funds (more than ten years). Longer-term bonds typically have greater interest rates, but they also come with more risks.
Given below are a few types of debt funds:
Liquid debt fund
Liquid debt funds invest in money market instruments with a short maturity period. It is an ideal short-term investment option that provides better returns than the usual bank interest rate.
Government bond
They are debt obligations that the respective governments issue. Treasury securities include treasury bills, notes, and bonds. These debt fund returns are one of the safest as the government backs them. Investors should note that debt fund taxation in the U.S. means the income earned by treasury securities is taxable federally, even if it is exempt from state or local taxes.
Municipal Bonds
They are debt instruments issued by states, cities, counties, municipalities, and other governmental entities to support ongoing obligations and finance public utility projects. Debt fund taxation on Municipal bond interest is generally free from federal income tax. In addition, if the investor resides in the state where the bond was issued, the interest may be free from state or local taxes.
Corporate bonds
Investors who purchase corporate bonds are lending to the company that is issuing the bond. In exchange, the corporation agrees to pay interest on the principal and, in most cases, return the principal when the bond matures or comes due.
Private debt funds
Another classification of funds, such as the private debt fund, focuses on lending activity handled by companies other than banks. These funds raise funds from investors before lending them to various businesses. One uses a private debt fund as an alternative to banks' traditional lending.
Investment and non-investment grade
Bonds are also classified as investment grade or non-investment grade based on their credit ratings. Investment-grade bonds are more likely to be paid on time than non-investment-grade debts. Non-investment grade bonds, commonly known as high-yield or speculative bonds, have higher interest rates to reward investors for taking on more risk.
In addition, bonds can differ in terms of interest payments. Interest payments are called "coupon payments," and interest rates are called "coupon rates." A fixed coupon rate pays the same regardless of interest changes in the market rates. On the other hand, floating rates reset the bond interest rates periodically according to the changes in the market rates. They are usually determined based on a bond index or related benchmarks.
Example
David wants to invest, and he is looking at the criteria for investing in debt mutual funds. The data he analyzed is as follows:
| 5 Year. Returns | 3 Year. Returns | Min. Investment | Rating | |
|---|---|---|---|---|
| ABC | 19 | 14 | $1000 | Not available |
| XYZ | 10 | 8 | $1500 | Good |
From the data above, it is evident that there is an increasing rate of returns over a long period in the case of ABC here. But unfortunately, the rating of the fund is unavailable. This may mean that they do not possess payment credibility. In the case of XYZ, the interest rates are not much different from each other, even for a long period. However, XYZ has been rated good, meaning the company makes returns without default. This is the trustworthiness of the company, and investors can choose to put their money into a highly rated company.
Debt Fund vs Equity Fund
Equity Funds are a type of mutual fund scheme that invests their assets in stocks of various companies based on the underlying scheme's investment objective. Both concepts are different from each other. Debt mutual funds have fewer risks than equity funds in comparison. Debt or income mutual funds invest in government and company-issued fixed income instruments. Fixed income securities include corporate bonds, money market instruments, government securities, Treasury bills, and other debt securities. Debt funds are less risky than equity mutual funds and have the potential to provide higher returns than typical bank savings accounts.
Compared to equity mutual funds, debt mutual funds are invested in fixed income instruments and provide stable and consistent returns. As a result, debt mutual funds may be an excellent way to protect investments from market volatility. These funds are less risky and volatile than other types of market-linked securities. Another factor to be considered is that when compared to equity and other Mutual funds, the debt-income fund has lower transaction costs.
Frequently Asked Questions (FAQs)Â
These funds generate returns for investors by taking the money and investing it in government bonds and other fixed-income securities. As a result, they are relatively low-risk investments.
Investors can buy debt or income bonds after research and analysis. For this purpose, an investment account needs to be created, or they can take help from a financial advisor.
They like all securities, and investments are not risk-free. They carry risk but to a lesser degree than other instruments available in the market. These funds come with credit risk, interest rate risk, and prepayment risk, which investors should be aware of.
Short-term funds refer to those income funds that are best suited for investors with a low-risk appetite. They offer a moderate maturity period of one to three years. Stable returns and medium risk accompany them.
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