Debt Mutual Funds: How Do They Work?

Today, a plethora of investment options are available in the market to those looking at securing their financial future based on their goals, risk appetite and earnings. One aspect of financial empowerment is to understand how these investment tools work so you can make decisions without getting stressed and overwhelmed. 

Debt mutual funds can be best described as those unsung heroes of financial portfolios that work quietly in your portfolio to provide solid and steady returns and are that compass that guides you through the markets with precision and purpose. 

Before we delve into what Debt Mutual Funds are, let us try and understand what are Fixed-income Securities under which Debt Mutual Funds are included.

Unlike equity where you can get returns across a range of positive to negative returns based on how the firm performs, fixed-income securities are investments that have a fixed rate of interest that they pay out as returns. This interest payout rate is known in advance and varies across different types of fixed-income securities depending on how risky they are. 

Government securities are usually known to have the least amount of risk, as the risk of default by the Central Bank is deemed to be extremely low in most countries and is considered to be a risk-free investment. Government securities are usually split into 2 categories - Treasury Bills (or t-bills) where the duration is less than 1 year, and bonds where the duration is 1 year or higher. 

As we move towards riskier fixed-income securities, you have options like bank fixed deposits and corporate fixed deposits. Banks are riskier than G-Secs, although all FDs within Indian banks are insured up to a limit of INR 5 lakhs. This means that even if a bank goes under, your money up to 5 lakhs (whether in a savings bank or FD) is insured against loss. 

So, How Do Debt Mutual Funds Work? 

Well, they make a pool of money invested by you and other investors and invest them in fixed-income securities. Unlike equity mutual funds, which primarily invest in stocks, debt funds primarily allocate their assets in bonds, government securities, and other fixed-income instruments. These funds provide a steady income stream and are generally considered less volatile than equity funds. They are stable and predictable and are just the right choice for risk-averse investors.

A lot of people do not like the stress of a volatile market, they want to play it safe and keep their earnings secure and do not want to take higher risk. The earnings here are regular,  stable and consistent and help mitigate the impact of market fluctuations. However, since risk and reward have an inverse relationship, the returns in these funds will be lower than equity funds or investments in equity.

Some investors like to diversify their investments within their mutual funds’ portfolio thereby, spreading risk across various fixed-income instruments. This diversification helps and enhances overall stability. These funds are managed by professionals so they give you the comfort of sitting back and having someone with more expertise take over. The professionals analyse market conditions and make investment decisions on behalf of investors. 

Compared to fixed deposits where you are locked in till maturity or can exit only with a lower interest rate than when invested, the flexibility of Systematic Withdrawal Plans (SWPs) in debt mutual funds allows investors to generate a regular income without triggering taxes on the entire investment. 

There are several types of Debt Mutual Funds also and based on your financial and life goals, risk appetite and money available you can choose to invest in liquid funds which are very short-term debt instruments like Treasury Bills and commercial papers. The Short Duration Funds and the Ultra Short Duration Funds invest in a mix of short-term debt instruments with slightly longer maturities than liquid funds. And are ideal for investors with a short to medium-term investment horizon. 

Long Duration Funds are best for long-term investment horizons and higher risk tolerance with an investment period that exceeds 7 years.  Dynamic Bond Funds are based on interest rate movements and are great for those who have an actively managed approach to debt investments. Corporate Bond Funds primarily invest in corporate bonds. 

Gilt Funds are funds invested in government securities (gilts) and Credit Risk Funds invest in lower-rated debt instruments, offering higher yields but with higher credit risk. Banking and PSU Funds invest in debt instruments issued by banks and public sector undertakings (PSUs) and Fixed Maturity Plans (FMPs) have a fixed maturity date and invest in debt instruments with a similar maturity profile.