How Do Debt Mutual Funds Work in India?

Total assets under management (AUM) of debt mutual funds in India, stood at ₹13.24 trillion, as of June 2019, accounting of 51% of the total AUM of the mutual fund market in the country. More importantly, debt funds surpassed fixed deposits in terms of returns, says an article by Livemint.

If you are interested in investing in debt funds, here’s a complete guide on how they

work.

Debt mutual funds, also known as fixed income funds, invest in listed or unlisted debt instruments, such as government/corporate bonds or treasury bills. The difference between the cost of investing and the selling price forms the appreciation or depreciation in the Net Asset Value (NAV) of the fund. Apart from this, they also get regular interest from the debt instruments in which the money is invested.

In context of returns, the debt funds that provide interest on a regular basis from fixed income instruments are quite similar to FDs. The interest amount gets added to the fund daily. In case the interest is received annually, it gets divided by 365 and the NAV of the fund increases by this amount. So, the NAV depends on the rate of interest of the constituent assets, as well on any increase or decrease in the credit rating of the holdings.

The price of debt fund securities change with fluctuations in interest rates. For instance, suppose your debt fund has a security that gives 15% interest. If the interest rate declines in a particular financial year, the instruments issued in that year would provide this lower rate. And, to match this altered rate, there will be an increase in the price of your debt fund’s instruments, since they have a higher rate. Due to a cascading effect of the increase in prices, the NAV of your fund would also increase.

As compared to equity funds, debt mutual funds are considered comparatively safer investments. This is because during times of market decline, the NAV of equity funds plummet sharply, while that of debt funds does not fall as drastically. However, remember that these funds can only provide moderate returns, whereas equity funds offer higher returns in the long term, albeit at a much higher risk.

There isn’t any hard and fast rule regarding who should choose a debt fund. It depends on your investment goals and risk appetite. For example, if a person wants to buy a new home after 2 to 3 years, they can consider investing in both long and short term debt funds. Other ways in which a debt fund can be used are:

• For diversification of your investment portfolio through different asset classes.
• To reduce risk when you are close to achieving your financial objectives.

Some other advantages of these funds are their comparatively stable returns and liquidity, as well as low cost structure.