What is a Debt Fund?

A debt fund is a type of mutual fund scheme that invests in fixed-income instruments like corporate bonds and government bonds, corporate debt securities, money market instruments, etc. These funds are professionally managed by asset management companies (AMCs) and are well-suited for investors seeking a relatively stable and predictable source of income.

Debt funds offer diversification across a range of debt instruments, which helps mitigate risk, and they are known for their liquidity, allowing investors to buy and sell units easily.

The returns from debt funds are generated through interest income and capital appreciation, and their taxation depends on the holding period, making them a versatile choice for various investment goals and risk profiles. These funds are also known as income funds or bond funds.

How Debt Funds Work?

Debt funds invest your money in various debt instruments, such as corporate or government bonds. They invest in these instruments at lower cost and sell them later on margin in the future. The difference between the buying and selling price of the instrument increases or decreases the NAV of the fund. 

If the selling prices are higher than the buying price, it results in appreciation in NAV; however, if it is lower, it leads to depreciation in NAV. 

As they invest in debt instruments, they regularly receive interest, similar to Bank FDs. These interest incomes are added to the fund, increasing its NAV. 

NAV of the debt funds also gets influenced by the interest rate of the underlying assets and their credit rating. As interest rates change in the market, the price of a bond also changes. 

For example, if the market interest rates go down, it usually means new bonds will have lower annual interest rates. Let’s take an example to understand this: 

Assume your fund has invested in a debt instrument offering an annual interest rate of 8%. But now, after a fall in the market interest rate, they might be issued with 6% annual interest. This change may increase the price of the 8% bonds to match the return of lower interest rate bonds.  As a result, when the bond price increases, it increases the NAV of the fund.