What Are Debt Funds & How Do They Work?

By Author: QuantumAMC
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Debt Funds or Debt Mutual Funds primarily invest the money in fixed-income securities like government securities, debentures, corporate bonds and other money-market instruments. These funds lower their risk by investing in such avenues. They have relatively low volatility and generate risk adjusted returns over time.

How do Debt Funds Work?

These funds invest in instruments such as Bonds and fixed income securities to generate returns for the investors. These funds buy these instruments and earn interest on the money. The yield that the investors receive is based on this.
The portfolio of debt funds needs to have specific maturity ranges. For example, a liquid fund can buy only securities which have maturities of upto 91 days. They do not offer assured or fixed returns, unlike FDs. Their returns can fluctuate. A rise in interest rate positively impacts on the interest income but negative impact on the bond or instrument price. And it’s the other way ...
... round when the interest rates fall.

What are different types of debt funds?

1) Liquid Funds:
This category of funds are considered the least risky among the mutual funds. As the name suggests, they are highly liquid. The portfolio of this fund comprises instruments that have a maturity period of not more than 91 days.

2) Dynamic Bond Funds
In this fund, the fund manager changes the maturity of the portfolio depending upon the forecast of the interest rates. If the forecast indicates a rising interest rate, then the maturity will be longer. If the forecast is indicating a falling interest rate, then the maturity will be a shorter duration.

3) Short / Medium / Long Term funds
Short term Funds come with a maturity period of 1 to 3 years. The portfolio in these funds are structured such that their prices are not much impacted by the change in interest rate movements.
Medium Term debt funds have a maturity period of upto 3 to 5 years, and long-term debt funds have maturity beyond 5 years. These are riskier than short-term as their tenure is longer; hence more significant is the impact of the interest rate on the portfolio, which is also known as interest rate risk or duration risk.

4) Fixed Maturity Plans
These schemes are closed-ended schemes. But can be traded on stock exchange where they are listed.

Debt funds are ideal for investors seeking moderate risk as the risk of investing in debt mutual funds is generally lower than in equity mutual funds. Debt funds can be the right choice for anyone having a lower appetite for risk. You can invest in a debt fund if you have a surplus fund or want to diversify your investment portfolio, or think of making an emergency fund. Debt funds can also diversify the overall portfolio risk if your allocation towards the equities are on a higher side.

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