One of the disturbing but common mistakes that novice investors make is directing all of their funds into one type of investment. A well-diversified portfolio is ideally the mark of a successful investor. In a nutshell, this implies that the investor must be exposed to various asset classes.

Apart from equity, debt is a significant asset class. Debt is among the most prominent markets in which investors can invest their money to multiply their wealth. Debt funds are an important sector that should be included in the portfolio of those just starting in the investment world. But, before delving into the specifics of what to know before selecting a debt fund, one must first comprehend what a debt fund is and how it works.

What is a debt fund?

The majority of a debt fund’s assets are invested in fixed-income producing instruments such as bonds, government securities, certificates of deposit, treasury bills, commercial papers, banker’s acceptance, etc.

These have a fixed maturity period as short as one day or as long as seven years. Because the returns are not affected by market fluctuations, they are regarded as less risky than equity funds. An investor receives their principal, interest, and returns or profits at the end of the maturity period. The interest rate is also predetermined at the time of investment. 

How do debt funds work?

When the Indian government wants to start a new development project, such as building ports to increase imports, or when a major corporate house needs short-term investment funds to develop its enterprise, liquid mutual funds are required. Borrowing from a lender is one option for the corporate or government entity.

A financial institution, such as a bank, could be the lender. If the borrower obtains a loan from a bank, they will receive cash inflow, and, once the loan term is completed, they will repay the loan amount plus interest. Bonds are another way for a corporate or government entity to borrow money.

  • Price Appreciation

Another feature of debt instruments, including corporate bonds, is their trading ability. Their market value fluctuates according to market demand and supply. A debt mutual fund, for example, decides to invest in a corporate bond with an annual interest rate of 11%.

Other bond funds enter the market, offering lower interest rates, such as 9%. The former bond’s value will rise as a result, as might demand. This raises the Net Asset Value of the mutual fund that owns this bond.

  • Interest rates

Let’s take a look at how this type of debt fund works. Assume that you must raise a specific amount to expand into another city. It decides to borrow from the general public rather than a bank. As a result, it issues a debt instrument known as a corporate bond. Retail investors and financial institutions such as mutual fund companies, purchase this corporate bond.

These bonds have a fixed maturity date, and an interest rate determined when the bond is purchased. You can invest in these bonds as a retail investor through mutual funds. You will be paid interest based on predetermined terms. You will start receiving your principal investment back when the bond matures.

Who can invest in debt funds?

Debt funds invest in all types of securities. Thus they are accessible to investors, including those with a low-risk tolerance and those with a high-risk tolerance. Although there are no guarantees, the returns offered by debt funds are frequently within a reasonable range. However, specific considerations must be made before investing in a debt fund.

Final Thoughts

In several announcements and advertisements, we have heard the phrase, “Mutual funds are subject to market risks.” Debt funds are among the safest mutual funds available in the market, with predictable returns, convenience, and increased liquidity making them one of the most searched investment instruments in the market, particularly by investors with a low-risk appetite. The only thing to remember is to do thorough research before embarking on your investment journey and look for the best-performing funds to maximize returns.