In earlier posts I discussed how equity funds will work best in fulfilling your long-term goals. But what about short-term goals?
Also, not every investor is willing to take the risk of unpredictability and volatility by investing in equity.
For better understanding of debt mutual funds, it is important to understand its underlying asset “Debt instruments”. Debt is synonyms with loan. Various entities like government, private companies, or financial institutions issue bonds to raise money and debt funds invest in these loan instruments.
Government borrows money to fund its excess expenses, or for improving the infrastructure etc. In this process government issues debt instruments like bonds. Companies borrow money for funding their working capital requirements, or to meet its capital expenditure. Like the government, they also issue different debt instruments like corporate bonds & debentures.
These instruments carry a particular interest rate and maturity period. The maturity of these instruments can be anything from a few days, to a few months, to a few years.
These debt instruments are I OWE YOU agreements. This obligates the issuer of these instrument to pay the lender a specified amount of money at regular intervals & the principal amount at a future date.
But it is not easy for small investors to invest in these instruments directly. Firstly because they are expensive and secondly because they are not easily available for trading in secondary markets. So, they can invest indirectly through debt mutual funds.
Debt funds invest in these debt instruments on behalf of investors & pass on the interest earned along with capital gains (if any).
Debt funds can generate returns in two ways :
- From earning interest payments at fixed rate of return as mentioned on the instrument. Duration of these payments can be monthly, semi-annually or annually.
- By capital appreciation when the face value of invested instrument increases in future.
Debt funds are less riskier than equity mutual funds. They offer low risk and stable income. But they are not completely risk free. Like any market instrument they also carry some element of risk.
Just like shares, debt instruments are also traded and price of these instruments move up and down. Since, debt market is not as volatile as equity its price movements are more predictable.
But it is important to understand the 2 main types of risk involving debt funds:
- Interest Rate Risk
Debt instruments’ price moves up and down along with change in interest rates. There is a inverse relation between these two. Whenever interest rate goes up the debt instrument’s price comes down and vice versa. Let’s understand this with help of an example.
Assume that there is a bond available in market that pays interest @ 9% p.a. The interest rates fall in the economy. Now, newer bonds will be issued at a lower interest rate, say @ 8% instead of 9%. This means that the demand for the 9% bond will rise as it will earn more money compared to newer bonds. Increased demand will increase the price of this 9% bond. Mutual funds that have this 9% bond in their portfolio become more valuable as their NAV rises. If interest rates rise your mutual fund scheme will see its NAV fall.
Therefore, depending on current interest rate, you can either make profit or loss. The longer the duration of an instrument the more vulnerable it will be to interest rate changes.
- Credit Risk
Since debt instruments are based on loans there is always a risk that the borrower might defaults on repayments. Apart from government issued instruments (Gilt Funds) all other instruments carry varying degree of credit risks.
Organisations are graded on their credit worthiness. In other words they are awarded different grades based on their ability to meet interest and principal repayment on time. Higher the credit rating means less chances of default. Lower the credit rating, riskier the debt instrument.
Debt mutual funds are the safest form of mutual fund schemes because they carry low risk. But the downside is that their returns are also lower than equity-based funds. It all depends on your risk appetite – if you want to play it safe or are just starting with mutual funds and want to wet your feet go for debt funds.
Happy Investing 🙂