Debt Funds: Where Does Your Money Go?

Debt funds are a type of mutual fund that generates returns by lending money to governments and companies. They are considered a low-risk investment option, as they invest in fixed-income securities such as corporate bonds, treasury bills, government securities and money market instruments. These funds are suitable for investors seeking regular income, conservative or first-time investors, and those looking for greater returns than bank deposits. Debt funds offer high liquidity, flexibility in investment, and stability, making them a popular choice for those with short- to medium-term investment horizons.

Government debt

Debt funds are a type of mutual fund that generates returns by lending investors' money to governments and companies. Debt funds are considered low-risk investments, and they invest in securities that generate fixed income, such as treasury bills, corporate bonds, commercial papers, government securities, and other money market instruments.

The lending duration and the type of borrower determine the risk level of a debt fund. Debt funds that lend to governments are generally considered to pose the least risk. The US government, for example, issues a wide range of securities for investment, which are considered the lowest-risk fixed-income investments in the market.

The risk associated with government debt funds primarily depends on the country's political and economic environment. While government debt funds are generally considered low-risk, investors should be mindful of interest rate risk and credit risk. Credit risk refers to the default risk of the government not repaying the principal and interest. Interest rate risk, on the other hand, refers to the impact of changing interest rates on the value of the fund's securities.

In summary, government debt funds are a type of debt fund that invests in government securities. These funds offer stable and predictable returns, making them attractive to low-risk investors. However, it is important to consider the associated risks, such as interest rate risk and credit risk, when investing in government debt funds.

Corporate debt

Corporate bonds are a type of debt fund, which are investment pools that primarily contain fixed-income investments. Debt funds are often referred to as credit funds or fixed-income funds and are considered low-risk vehicles.

Corporate bond funds are a type of debt fund that lends at least 80% of their money to corporations with the best credit ratings possible. This rating is only granted to organisations that are financially sound and have a good likelihood of repaying lenders on schedule.

The significant features of corporate debt funds include:

• Higher returns than other debt instruments in the market.
• Short-term nature, as they are generated to satisfy the short-term financing requirements of businesses.
• High liquidity, allowing investors to convert their investment to cash as and when needed.
• Lower associated risk than shares, as they pose a financial obligation (liability) to the company.

There are two main types of corporate bonds that mutual funds invest in:

• Top-rated companies with incredibly high credit ratings, typically top public sector companies and Navratnas.
• Companies with a slightly lower credit rating of AA-.

Corporate bond funds are taxed differently depending on how long they are held. If the holding term is less than three years, the tax is calculated using the applicable income tax slab rate. If the holding term exceeds three years, the tax is 20% after the indexation benefit is applied.

Money market instruments

Money market funds are a type of mutual fund that falls under the broader category of fixed-income investments. These funds aim to maintain a net asset value (NAV) of $1 per share, and any excess earnings are distributed to investors as dividends. While money market funds are not insured by the FDIC, they are protected by the Securities Investor Protection Corporation (SIPC).

The types of debt securities held by money market funds are typically very short in maturity and high in credit quality. Investments can include short-term U.S. Treasury securities, federal agency notes, Eurodollar deposits, repurchase agreements, certificates of deposit, corporate commercial paper, and obligations of states, cities, or other types of municipal agencies.

Money market funds are suitable for investors with short-term investment goals, low tolerance for volatility, and a need for high liquidity. These funds provide stability and are often used to offset the volatility of bond and equity investments. They are also useful as short-duration investments for emergency savings or as a holding place for assets while waiting for other investment opportunities.

Overall, money market instruments are a safe and stable investment option for those seeking low-risk and high liquidity.

Floating rate debt

Debt funds are a type of mutual fund that generates returns by lending money to governments and companies. They are considered low-risk and are usually sought by investors looking to preserve capital and/or achieve low-risk income distributions.

FRNs typically pay a lower yield to investors than their fixed-rate counterparts because they are benchmarked against short-term rates. However, if the short-term benchmark rate falls, so does the rate on the FRN. There is no guarantee that the FRN's rate will rise at the same pace as interest rates in a rising-rate environment, as it depends on the performance of the benchmark rate.

Securitized products

The first products to be securitized were home mortgages, followed by commercial mortgages, credit card receivables, auto loans, and student loans, among others. Bonds backed by home mortgages are called mortgage-backed securities (MBS), while those backed by non-mortgage-related financial assets are called asset-backed securities (ABS).

Debt funds, such as mutual funds or exchange-traded funds, may invest in securitized products as part of their fixed-income offerings. These funds offer lower fees compared to equity funds due to lower management costs.

Frequently asked questions