How do Debt Mutual Funds work?

If you thought mutual funds were all about stocks/equity, you are probably not alone! This may be a common perception, but mutual funds have more to them than just equity. They offer something for every investor, and debt mutual funds are a huge part of their offering.

Debt mutual funds invest your money in fixed income instruments like bonds, Government securities, and treasury bills, aiming to generate returns. What you are doing here is lending money to other corporates or to the Government and getting interest on this lending. In this process of lending, the borrower issues to the lender, say, a bond. Let us understand debt mutual funds returns and how debt funds work in detail.

If a company wants to raise money, it has three options-

1. Sell shares of the company in the stock market
2. Borrow money from a financial institution, like a loan
3. Borrow money by issuing bonds

These bonds generally have a fixed maturity period and a pre-declared interest amount that the lender will get year-on-year. For example, if you invested Rs 1000 in a bond of 5 years and 5% interest per annum, you will get Rs 50 every year as interest for 5 years. At the end of 5 years, you will get your principal amount of Rs 1000 back.

How debt funds work is, they collate the money from investors like you and then the fund manager purchases bonds of various companies depending on the fund’s objective.

Similar to how stocks are traded in the stock market, bonds can also be traded in the bond market.

We have answered the popular question- how do debt funds work? Let us understand how they gather returns. There are two ways in which debt funds gather returns.

Firstly, the issuers of the bonds pay interest, as mentioned above. This interest is passed on to the investors in the form of an increase in the Net Asset Value (NAV), i.e. the unit price at which you purchase the units of a mutual fund.

Secondly, the bond price fluctuates as interest rates fluctuate in the market. Suppose the interest rate in the economy falls - that would typically imply that any new bond being issued will be at a lower per annum interest rate. Taking the above example forward, this means that the bonds being issued at 5% per annum will now be issued at 4% per annum. This will result in an increase in price for the 5% bonds. Thus, if bond price increases, these gains are passed on to the investors via an increase in the NAV.

The type of debt fund and its investment objective determine how these returns are generated and how much risk does a debt fund holds.

Have we made you curious to know more about debt mutual funds? Click here to read about the types of debt funds and choose the one that suits your requirements.