Debt Funds in Detail

After researching Sectoral and Thematic Funds and their potential for focused investments, Ravi and Priya realised they needed to add more stable options to balance their portfolios. Priya, who favours consistent returns, questions whether investing can be done without being affected by the stock market's volatility.

Curious to diversify even more, Ravi advises that they investigate debt funds, a low-risk investment that preserves capital while providing predictable returns. In this chapter, they learn more about debt funds and how they can enhance their overall financial plan.

A debt fund pools investors' money and distributes it among different debt instruments offered by banks, businesses, or governments. The returns come from interest payments on these bonds or debt securities. The objective is maintaining the initial investment while generating income through consistent interest.

In general, debt funds are less risky investments; thus, they suit conservative investors who desire more stable returns. They tend to be less volatile: the value of your investment doesn't swing wildly compared to equity funds. That said, debt funds are not risk-free. Credit risk- where the debt instrument's issuer defaults, or interest rate risk- where interest rates rise and lower the value of existing bonds- are among the common types.

One of the most significant advantages of debt funds is predictable income. Since the funds invest in debt instruments that pay regular interest, you also get periodic returns. Therefore, these funds are ideal for investors who seek regular income. Besides, debt funds are far more liquid than most other investment avenues, such as fixed deposits or real estate. You can sell your units anytime, and the transaction is generally quicker.

Various debt funds are available and intended to suit different investment requirements. Short-term debt funds, for example, invest in debt instruments with relatively short maturity, whereas long-term debt funds invest in bonds with long-term maturity. Usually, Short-term debt funds are relatively insensitive to interest rate fluctuations. Hence, they are less risky if it's felt that interest rates could increase. Long-term funds generate better returns and greater risk due to possible changes in interest rate variation.

Another variant of debt fund investment is the liquid fund. These funds are invested in very short-term debt instruments and are meant to park money that one may require in the immediate future. These funds offer returns usually higher than a savings account can give but lower than longer-term debt funds. Liquid funds are low-risk and highly liquid; hence, they are suitable for emergency funds.

After that, gilt funds invest in government securities. These would be safer, as the government backs them, but the returns would be low compared to the corporate debt funds. A fund that invests in corporate bonds earns a higher return, but the risk of the firm failing to pay back increases.

When investing in debt funds, the returns are not fixed. The interest rates of the bonds held in the fund will fluctuate, and the bonds' values may change concerning market conditions. However, Debt funds are much more stable in the long run than equity funds. This makes them suitable for conservative investors or those who cannot tolerate much risk.

It is similarly essential to observe the credit ratings of the debt instruments the fund invests in. While investments in high-quality, well-rated bonds pose a lower risk, those in the lowest-rated bonds are usually risky. Credit risks can be higher in these cases because the issuer will default on interest and/or redemptions out of the lowest rating grade.

Conclusion:

As Ravi and Priya discover the predictability and stability of debt funds, they find that these can cover their portfolios. While less risky, debt funds maintain stability with an adequate growth rate.

In the following chapter, we will discuss hybrid funds, a unique amalgamation of debt and equity products that gives investors the best of both worlds. Thus, your investment strategies will improve.