What are debt funds? How can they play an important role in any investor’s portfolio?

1. Introduction to debt funds

For many retail investors, Mutual Funds are synonymous with Equity Funds and indeed many investors use the two terms interchangeably. However, there are a large number of Mutual Funds that do not make any investment in the equity market and are far lower in terms of their risk profile. One such category of funds is Debt Funds or Bond Funds. These funds invest in debt issued by entities such as the private sector or public sector companies and the central or state governments.

2. How do debt funds work?

Debt funds got its name as the investments are focused towards debt instruments. Debt as an asset class is more oriented towards income as opposed to equity which is oriented towards growth. Also, debt in contrast to equity tends to be more stable in terms of day to day price fluctuations. As a result of these two characteristics – i.e. an orientation towards income and a higher degree of stability – debt funds can play a useful part in every investor’s portfolio.

3. What are the different types of debt funds?

Within the broad debt fund characterization, there are a host of different strategies/funds that are available for investors. The chief differences are two-fold. First is the type of issuers that they invest in – for example, government v/s private sector, high quality credit v/s diversified. Second is the maturity of the instruments that they buy - ranging from the short term to medium and long term instruments. The first variable determines the riskiness of the fund from a credit perspective. The second variable determines the impact on the fund due to movements in interest rates and needs to be aligned broadly with the investment horizon of the investor.

4. Which investors should look at investing in debt funds?

Debt funds make sense for every investor. Since debt complements equity to a great extent, it is normally recommended for investors to carry out asset allocation – that is invest at a determined mix between equity and debt. The appropriate mix can change depending on whether investors want to prioritize growth or income objectives in their portfolio as well as the kind of overall risk appetite that the investor has.

5. Why do NAVs of debt funds fluctuate?

NAVs of debt funds represent the total value of their assets. These values can change over time due to two main factors – 1) the prices of the bonds in the portfolio changing and, 2) the coupon income accruing for each of the bonds. While the coupon income is stable in nature, the price can fluctuate up or down as a result of interest rate movements. However, over time, these fluctuations stabilize and the coupon rate tends to dominate the return profile of these funds.