Understand how a debt mutual fund works

If you want to start financial planning, the first step is to identify your topmost financial goals and to prioritize them as per their importance in your life. By doing so, you may be able to choose investments that will specifically target these set goals. Also, when you invest keeping in mind that you want to achieve something with the accumulated corpus, you are less likely to back out or stop your investments midway. A lot of investors begin their investment journey only because someone told them to do so. This way of investing is deemed unhealthy because you are bound to give up soon as you don’t have any defined motive or purpose for regularly saving and investing.

However, if you already know your goals and are looking for investment options you may consider mutual funds. Mutual funds are a pool of professionally managed funds that give investors exposure to various asset classes, foreign markets, and money market instruments through one single investment. These are market linked schemes that offer active risk management and may allow investors to earn capital appreciation over the long term.

Mutual funds can be broadly classified as equity and debt funds. Equity funds invest predominantly in stocks of publicly listed companies which is why several investors with low risk appetites refrain from investing in them. Such investors with low risk tolerance often consider debt mutual funds.

What are debt funds?
While equity funds invest a majority of their corpus in equity and equity related instruments, debt funds are open-ended mutual funds that predominantly invest in fixed income securities and debt related money market instruments for generating stable capital appreciation. Since the investment portfolio of a debt fund isn’t exposed to volatile equity markets, any fluctuations in the equity markets do not affect capital appreciation generated by debt funds. Debt funds invest in securities that come with different maturity periods and depending on the investment objective, a debt fund may either choose to invest in a portfolio of securities that mature over the short term or long term.

How do debt funds work?
Whenever the Indian government is in need of finances for developing the nation like building schools in rural India to educate and empower people living in far flung areas with knowledge or to build new ports to enhance the import-export trade it shall approach the central bank of India – the Reserve Bank of India(RBI). So also, if a conglomerate needs capital investment for the short term to expand its business, it reaches out to the Reserve Bank of India as it needs liquidity. The RBI then loans money from lenders i.e., financial institutions like banks and insurance agencies. The borrower, be it, the government and / or conglomerates, borrow money from banks thus, receiving cash inflow. In exchange, they promise to return the money with interest once the loan is repaid at the end of its tenure. Another way these organizations borrow money is through issuing bonds that are referred to as corporate and government bonds.

Here’s a simple example that illustrates how debt funds work –

Let us assume that an Indian automobile manufacturing company wants to raise funds to set up a new plant in another state to increase its production power. The automaker decides to reach out to the public to borrow the finances instead of going to the bank. In exchange, the automaker issues corporate bonds, a debt instrument. Mutual fund houses and Asset Management Companies managing debt funds invest in such corporate bonds. Such corporate bonds issued by companies or governments come with a fixed maturity period and interest rate that is determined when selling the bond. Retail investors can invest in these bonds through mutual funds. When the bond attains its maturity, the debt fund receives its investment back and the investors benefit from the interest which the scheme earns in the process.

Another way in which a debt fund may earn capital appreciation is through price appreciation.

Suppose, the debt fund you invested in invests in a corporate bond that offers a 10% interest rate. And if a new corporate bond enters the market offering an 8% interest rate, the value of the bond in which your debt fund invested increases. But you may wonder, “How does the fund manager decide which bond to invest in?”. Each of the bonds issued has its credit ratings. Bonds with low credit ratings may yield better returns than bonds with high credit ratings. However, low credit rated securities are extremely volatile and hence it is essential for investors to carefully study the investment objective and the underlying portfolio of a debt mutual fund before investing.

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