Debt mutual funds – Everything you need to know before investing

A part of your income is for daily expenses, and a part of your income should be saved for rainy days. However, savings alone cannot beat inflation. That why investing your hard-earned money becomes pertinent. For individuals looking to build inflation-beating wealth, mutual fund investments can be a good option. And for those who are concerned about the risk factors associated with mutual funds, they can consider starting their investment journey with debt funds.

Debt funds invest a sizeable portion of investors’ pooled money in fixed-income instruments like debentures, government securities, corporate bonds, treasury bills, and money market instruments. While debt funds may not provide as high returns as equity funds, they are relatively stable compared to equity funds and can be a suitable choice for risk-averse investors.

However, there are some factors to consider before investing in debt mutual funds. Let’s have a look at some of them:

Identify your investment goal, time horizon and risk appetite

Investing money without a goal is like driving with no destination in mind. For any investment, the purpose of investment plays an important part. Therefore, you should know why you want to make a particular investment and for how long you plan to remain invested. Generally, debt funds are recommended to investors with a short to medium investment horizon of 1-3 years. Sometimes the tenure can be lower ranging from overnight to a longer term.

Another thing to bear in mind is that although a relatively stable investment option, debt fund investments are subject to credit risk and interest rate risk. So, you should always choose a fund that aligns with your risk appetite.

Know your debt fund type and its nature

You can choose the right debt fund only if you know the types of debt funds and how they work. Some funds are sensitive to changes in interest rates, while others are sensitive to changes in credit ratings. Based on their maturity period and how they react to market changes, debt funds are classified as below:

• Short-term debt funds: For investors who favour a short-term investment horizon, short-term debt funds can be a viable option. These funds invest in debt securities. Liquid funds, money market funds, overnight funds, etc., fall into this category.
• Medium-term debt funds: The maturity period of medium-term debt funds range from 1-4 years. They have the potential to generate relatively better returns on investment than short-term debt funds but at a risk higher than short term debt funds.
• Long-term debt funds: Investors with a longer time horizon of more than three years can consider long-term debt funds. Dynamic bond funds and corporate bond funds are two popular types.
• Gilt funds: These funds invest a minimum of 80% of the corpus in government securities with varying maturities. They are free from any credit risk but are subject to interest rate risk.
• Credit risk funds: Credit risk mutual funds are debt funds which invest in low credit quality debt securities. These funds have higher risks since they invest in low quality instruments. They bear a significant credit risk for potentially higher returns.

Risks in debt mutual funds

Although a relatively stable investment option, there are two main risks that debt mutual funds face. Let’s understand them:

• Credit risk: Credit rating agencies rate the fixed-income instruments contained in a debt fund basis the issuer’s creditworthiness and ability to repay. If the issuer defaults, the price of the instrument will get downgraded too.
• Interest rate risk: Interest rate risk is the potential for investment losses that can be triggered by an upward move in the prevailing rates for new debt instruments. Moreover, the longer the duration of the debt instrument, the higher is the sensitivity to interest rate changes.

To conclude, debt mutual funds are ideal for investors with a limited risk-appetite but who also wish for a comparatively better returns than those from a savings account. However, before you decide to put your money in debt funds, make sure you are aware of your investment goals, time horizon and risk tolerance. You must understand the types of debt funds – short-term, medium-term, long-term, gilt and credit risk funds – and the nature of each of them. Despite being a relatively stable investment option, debt mutual funds are also subject to certain risks. A thorough study of these risks is compulsory ahead of making an investment.

FAQs:

What is a debt mutual fund?

A debt fund is a type of mutual fund that primarily invests in fixed-income securities such as government bonds, corporate bonds, and money market instruments.

How do debt funds compare to fixed deposits in terms of returns and risks?

Debt funds have the potential to generate better returns than fixed deposits, but they also come with higher risks. Fixed deposits are considered relatively safe investments with guaranteed returns, while debt funds are subject to market risks and may not provide guaranteed returns. In certain market conditions, debt funds can provide negative returns as well. The choice between the two depends on an investor's risk appetite, investment goals, and time horizon.

How do I invest in debt mutual fund?

You can invest in debt mutual funds through various channels, including distributors, online platforms, and the fund house's website.

How to choose debt funds and what factors to consider before investing in debt funds?

When choosing a debt fund, investors should consider their investment goals, risk tolerance, and time horizon. They should also look at the fund's credit quality and average maturity. Consulting a financial advisor can help investors make an informed decision about which debt fund is best suited for their needs.

How do interest rate movements affect debt funds?

Debt funds are affected by interest rate movements because the value of the underlying securities in the fund's portfolio can increase or decrease based on changes in interest rates. When interest rates rise, the value of existing bonds in the portfolio decreases, which can result in lower returns for investors. On the other hand, when interest rates fall, bond prices tend to rise, which can increase the value of the fund's portfolio.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.