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Debt funds are mutual fund schemes that primarily invest in fixed-income instruments such as government securities, corporate bonds, treasury bills, and money market instruments. They are generally considered lower risk than equity funds and are often used by conservative investors for capital preservation and stable income.
How They Work
- Lending Mechanism: When you invest in a debt fund, you are essentially lending money to the issuer (government or companies) in exchange for regular interest payments.
- Returns: Returns come from two sources: the interest income (accrual) from the bonds and capital gains (or losses) arising from changes in the market price of the bonds, which are influenced by interest rate movements.
- Net Asset Value (NAV): The fund’s NAV is calculated daily and fluctuates based on interest rate changes and the credit rating of the underlying securities.
Common Categories of Debt Funds
Debt funds are categorized based on the maturity period of their underlying assets:
- Overnight Funds: Invest in securities maturing in 1 day; highest safety and liquidity.
- Liquid Funds: Invest in instruments maturing in up to 91 days; often used as an alternative to savings accounts.
- Ultra-Short/Short Duration Funds: Suitable for horizons of 3 months to 3 years.
- Corporate Bond Funds: Invest at least 80% in high-rated corporate bonds.
- Gilt Funds: Invest primarily in government securities, carrying virtually no credit risk.
- Dynamic Bond Funds: Actively adjust portfolio duration based on the fund manager's interest rate outlook.
Key Risks
- Interest Rate Risk: When market interest rates rise, bond prices fall, which can lower the fund's NAV.
- Credit Risk: The risk that the issuer may default on interest or principal repayments.
- Liquidity Risk: The risk that the fund manager may not be able to sell securities quickly to meet redemption requests.