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Simplified: How Do Debt Funds Work In India

When a company is looking forward to raising capital it does primarily by two means: equities and debt funds. Debts funds refers to that option where the companies borrow from the investors. In return for the capital raised, the company promises to pay interest to the investors at a fixed rate. This is the simplest manner in which the debt instruments work. Now, let us understand about the debt fund in more detail. 

What is a Debt Fund?

When an investor purchases the debt instrument, it means he is lending money to the financial entity that has issued the instrument. Debt instruments are fixed interest generating securities such as government securities, corporate bonds, debentures, etc. For investors, the primary motive of investing in a debt fund is to get a steady source of regular income in the form of interest as well as keeping the principal amount safe. As the income on these debt instruments are pre-decided, they are also known as fixed-income securities. Click to know more on debt funds

Debt Funds Working Process

When the capital is raised through the debt, the collected amount in different types of securities according to the fund’s credit ratings. Credit rating refers to the level of risk in making the returns to the investors by the debt instrument issuer. It is the responsibility of the fund manager to invest in securities that pay high credit ratings. Higher credit ratings signifies that the debt instrument issuer can pay the returns with more credibility and this includes both the interest amount as well as the principal amount. 

Types of Debt Funds

There are different types of debt funds and some of them are as follows: 

Liquid Funds

As the name suggests, these offer the highest liquidity among all debt funds. These funds invest the money in debt instruments where they do not have to hold the money for no longer than 91 days. In some investments of these, investors can withdraw upto Rs 50,000 on an instant basis. They are also widely considered to be the least risky form of mutual funds. 

Term Funds

If you have invested your money for a period of anywhere between 1-3 years, it will be considered short-term debt funds. These funds are compared less risky because the fluctuation in interest rate is not that steep in such a short span. 

Investments in debt in instruments for a period of more than 3 years but less than 5 years is considered as medium term investment. The risk is moderate here for the moderate fluctuation of interest rate risk. 

But if you are going for a long-term investment in debt funds, then the holding period is going to be over 5 years. The risk is highest here as the interest rate fluctuation is highest in such a long span. But since the risk is higher, you can also get higher returns in long-term debt instruments. 

Dynamic Bond Funds

With these types of debt funds, the fund managers can decide the maturity period based on the financial forecasts. If the forecast suggests the rising interest rate, the maturity period will be shortened down. Similarly, if the forecast indicates decrease in the interest rate then the maturity period will be extended. 

Fixed Maturity Plans 

If you go for Fixed Maturity Plans, then you will have to invest a considerable amount of money with a lock-in period. Once the FMP starts, you cannot invest any further in it. FMP resembles Fixed Deposits to a great extent. Although FMPs are a bit riskier than FDs. 

A debt fund can give a return of anywhere between 7% to 9%. However, it is important to read thoroughly about the debt instrument you are investing in, before you put your money on the scheme.