How Do Debt Mutual Funds Work? Understanding Debt Mutual Funds In Detail

In simple terms, a debt mutual fund is a type of low-risk mutual fund that invests in fixed-interest-earning securities such as government securities, treasury bills, corporate bonds, and a range of other money market securities. The primary reason debt mutual funds are attractive to investors is that they offer a steady income stream at competitive interest rates. Debt mutual funds are good investment choices for those investors who are looking for short-term to medium-term investments with relatively stable and low-risk returns. Let’s take a closer look at understanding how debt mutual funds work.

Debt mutual funds invest in a variety of different debt instruments/securities based on their credit ratings. Every debt instrument and security comes with its own credit rating that determines the amount of risk of defaulting on the interest payments. The best debt mutual fund managers are responsible for ensuring that investments are only made into highly rated securities to minimise risk.

However, the debt fund manager may also choose to invest a small portion of the funds into high-risk securities for a chance at higher returns. The returns on debt funds may be provided periodically or at maturity depending on the type of debt mutual fund chosen by the investor. Generally, debt mutual funds are considered to be a safer investment choice compared to equity mutual funds but have lower returns in comparison.

Generally, debt funds are classified on the basis of their maturity periods and built to cater to the needs of a diverse set of investors. Let’s take a look at the major types of debt funds:

Dynamic Bond Funds

Dynamic bond funds are a type of debt mutual fund that invests in a diverse set of debt instruments and securities with no specific maturity period. The maturity periods and securities are decided by the fund manager based on the current interest rate regime.

Liquid Funds

Liquid funds are a type of debt fund that invest in debt instruments/securities that have a maturity period of 91 days. These funds make a great alternative to savings bank accounts for investors who are looking for short-term liquid investments. 

Corporate Bond Funds

Corporate bond funds are a type of debt mutual fund in which a minimum of 80% of the funds are allocated towards corporate bonds with the highest credit ratings. This helps in minimising the risk and providing low-risk stable returns to the investors.

Gilt Funds

Gilt funds refer to those debt mutual funds which only invest in government securities such as treasury bills, government bonds, dated securities, etc. Since these securities are backed by the government, the risk is extremely minimal and the returns and guaranteed. These funds make a good choice for investors who want very low risk.

Ultra Short and Low Term Funds

These are debt funds that invest in debt instruments and securities that have a very low maturity period, i.e., from 3 months to 1 year. People who wish to invest money for the short term can consider investing in these types of funds.

Short Term Funds

Under short-duration debt funds, investments are only made into those securities or instruments that have a maturity period of 1 year to 3 years. These are also a choice to consider for short-term investors.

Medium To Long Term Funds

Under these types of debt mutual funds, investments are made into those debt instruments or securities that have a maturity period between 3 years to 7 years. These funds are ideal for those investors who wish to invest their money for multiple years at a time.

Long-Term Funds

Long-term mutual funds are those in which investments are made into securities and debt instruments that have a maturity period of more than 7 years. These funds can be chosen by investors who wish to invest their money for very long periods of time.

Things to Consider Before Investing In Debt Mutual Funds

Although debt mutual funds are considered to be relatively safer than equity mutual funds, there are certain important things that investors need to keep in consideration. Investors should only choose those debt funds that match their risk appetite. Debt fund managers also charge a very small percentage of your total capital as their fee, which is a cost to be considered. Most importantly, investors need to consider how long they wish to invest their money and decide the duration of the debt mutual fund based on their personal financial requirements.