What are Debt funds and how do they make money for investors?

Debt funds are a type of mutual fund which lends money to entities and earns interest on invested amount. Debt funds lend money by purchasing Government bonds (or other approved fixed deposits etc) and hence are considered to be a safer.

Debt mutual funds “loan” money instead of “investing”, hence these mutual funds are considered “safer”.

The concept of debt mutual funds is similar to Fixed Deposit (Bank FD). In a Bank FD, account holders(like you and me) receive a fixed interest for lending our money to banks. The bank lends our money to others entities(businesses etc) and charges an interest. The interest rate charged by banks is generally higher than what they give us and hence banks make money(from customers deposits).

How to debt mutual funds operate?

Debt mutual funds invest money in fixed income instruments such as Government Bonds, Corporate Bonds, Money Market Instruments etc. The return on investment for debt funds happens in two forms:

  • Regular interest at fixed rate
  • By the increase of the underlying price of holding instruments.

How are debt funds linked to interest rates?

Generally, debt funds returns are inversely proportional to interest rates. Hence, if the interest rates increase the return from debt funds reduces.

Let us see, take an example to see, how this relationship works:

Let us say that a company issues a bond saying that it will offer 10% interest rate to its investors for next 5 years. At this time, let us assume that banks were offering a 8% interest in fixed deposits. Since the banks are offering a lower interest rate, debt mutual funds would invest in the companies bond.

Now, let us say that in next 2 years, banks start offering 11% interest because of change in RBI policy. Now since banks offer higher interest rates, debt funds would want to sell the bond because the interest rate offered is less than the bank. However, the market will have no buyer and hence the value of the bond will reduce.

Are debt funds risk-free?

Although debt funds are “safe” investment, they are not risk-free because of following reasons:

  • Interest Rate Change

As discussed earlier, if the interest rate rises in the economy, the bond price falls and vice a verse. Since debt funds invest in bonds, the rise in interest rate would ultimately result in a fall of the debt fund.

  • Default from Bond Issuing authority

Defaulting on a loan means that the person or company who took the loan could not make the interest payments as per the contract. Although not very likely, at times bonds issued by companies also default. To help investors select good quality bonds, various credit rating agencies rate different bonds from AAA to D(Highest AAA and lowest D). High rated bonds (AAA) have almost zero risks of default and hence offer least interest rate (because investors money is safe). Whereas D rated bonds offer highest interest rates because the only way these companies can raise funds is by offering a higher rate of return.

  • Liquidity Schemes

At times, bonds issued by certain companies become ill-liquid ( for example if the company defaults on payment). Hence no-one wants to buy these bonds, causing the existing bond to take heavy losses while trying to sell their positions.

Different types of Debt Funds

There are different types of Debt Mutual Funds and the main difference between them is the type of financial instrument & time for which they invest. Let us look at various debt funds operating in India:

  • Liquid Funds ( Money market schemes )

As per SEBI rules, these Liquid funds can invest in securities with a maturity period of up to 91 days. These schemes invest in short-term instruments like Treasury Bills, commercial paper, inter-bank call money market etc.

  • Ultra Short Term Funds

The average maturity period of ultra short-term funds is around 270 days. These funds typically invest in Corporate Deposits and Commerical paper with bit longer expiry. Ultra Short Term Funds are preferred by investors who are willing to increase their risk with an aim to earn better returns.

  • Short-term debt funds

The average maturity periods of Short-term debt funds is around 2 years or a maximum of 3 years and they typically invest in Corporate bonds.

  • Long term debt funds

Long-term funds recommend holding periods of three years(or more) for better returns. Returns are highest if investors are able to invest, “before” the central banks starts a rate cut cycle because then investors would have bought a bond offering higher interest rate than available in the market, hence bonds NAV would rise.

  • Gilt Funds

Gilt funds invest in government securities (G-Secs). Because the bonds are issued by the central government, they have no risk. However, these funds are highly vulnerable to the changes in interest rates. A hike in interest rates would mean that these funds would lose value whereas a drop in interest rate would translate into great profits.

Capital gain for Debt Funds

Although not risk-free, debt mutual funds are considered less risky and hence are taxed higher than equity mutual funds. Below table illustrates the Taxation of Debt funds

Holding period of debt fund.Capital Gain ClassificationTaxation
Less than 37 monthsShort Term Capital GainAdded to income and taxed as per income tax bracket.
More than 37 monthsLong Term Capital GainFixed 20% tax along with Indexation benefit.