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What Are Debt Mutual Funds & How Do They Work?

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August 19, 2022


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The world of mutual funds can be quite confusing. With so many options like debt funds, equity funds, hybrid funds, and tax saver funds, it can be challenging to decide what kind of funds to include in your portfolio. 

The only way to resolve this dilemma? To understand each kind of investment avenue.

Today, we’re going to learn everything about debt mutual funds. Let’s begin with the basics!

What is a Debt Fund? 

A debt fund is a kind of mutual fund. As the name suggests, mutual funds use mutual capital pooled together that is then managed by an asset management company or AMC. This mutual corpus is invested in different assets based on the objective of the mutual fund scheme.

In the case of debt funds, capital is used to predominantly invest in debt or fixed-income instruments. Want to know what kind of securities fall under this category? Here’s a preview of the common debt instruments -

  • Government bonds
  • Corporate bonds
  • Corporate debt securities
  • Money market instruments 

Generally, debt funds invest at least 65% of their collective corpus in such debt securities. The remaining funds in the corpus may be invested in other assets like equity to diversify the mutual fund’s portfolio. 

Why Are They Called ‘Debt’ Instruments?

Let’s back up a bit and focus on the assets that debt mutual funds invest in. Why are they called debt instruments? And if they’re under the category of ‘debt,’ how do they qualify as investments? Because debt, after all, means liability. 

Debt is a liability, but only for the borrower. When you invest in a debt instrument like a government bond, you’re not the borrower. Rather, you are lending the money you invest to the government. The government (or any other entity issuing the security) resorts to debt funding to meet its cash flow needs.

This makes you the lender. And the government/entity issuing the bond becomes the borrower. So, for the issuer, this is a debt. And for you - the lender - it is an asset or an investment. This is why when you invest in a fixed-income debt instrument, the issuer typically pays out interest to you at a fixed rate known as the coupon rate. That is the cost of borrowing for the bond issuer. 

Now, coming back to mutual funds - the funds that invest in debt instruments are known as debt funds to identify the primary asset class in the fund’s portfolio. So, now that you know why these securities are called debt instruments, let’s check out how debt funds work.

How Do Debt Mutual Funds Work?

To understand how debt funds work, we need first to take a closer look at two different concepts - what the Net Asset Value (NAV) of a fund is and how a debt fund earns returns. Let us begin NAV.

The Net Asset Value

Every debt fund, like every mutual fund, is divided into units. The Net Asset Value (NAV) is calculated for each unit using this formula -

Now, if the total assets of a fund increase, the NAV will naturally go up. This is because the number of units remains constant. And how do the total assets of a fund increase? Well, that happens in one of two ways, as you’ll see in the section below.

How Do Debt Funds Make Money? 

A debt mutual can make money in two ways — through interest gains and through capital gains. 

Interest Payments 

Interest payments come from the securities and instruments the debt fund invests in. These interest earnings are added to the debt fund’s asset value. So, naturally, assuming the fund's liabilities do not go up, interest earnings will cause the NAV to go up too. 

Capital Gains

Capital gains occur when the value of the debt securities in the fund’s portfolio increases. The major reason for this change is interest rate changes in the economy. 

Suppose a fund invests in a government bond that pays interest at 6% per annum. On account of interest rate changes, say new government bonds are issued at an interest rate of 5%. This means investors can earn higher interest on the old bonds when compared to the new bonds. So, the value of the old bond goes up since they are now more valuable to the investor. 

This results in an increase in the fund’s asset value, and consequently, a rise in the NAV.

So, you know now that the NAV of a debt fund can go up in two ways -  

  • Through the regular interest accruals from the securities in its portfolio
  • Through the gains that occur when the interest rates fall, leading to a rise in the value of the securities

Like this, the NAV fluctuates daily. This means the NAV of the fund when you make your investment will likely be different from the NAV when you sell your holdings. The difference in NAV results in profits or losses for you. 

What Are the Different Types of Debt Mutual Funds?

Debt mutual funds can be categorised based on the kind of assets and the maturity of the assets they invest in. Here is an overview of the different types of debt mutual funds.

What Are the Risks Associated with Debt Funds?

Debt funds carry much lower risk than market-linked funds because the returns on debt instruments are more or less guaranteed at a fixed rate. However, that does not mean that debt funds don’t come with any risk. Typically, there are two kinds of risk associated with these mutual funds. 

Credit Risk

Credit risk is the risk that the issuer of the debt instrument may default on their interest or maturity payments. In other words, it is the risk of default. Typically, government securities carry the lowest (almost zero) credit risk because they are backed by the government’s sovereign guarantee. 

Corporate bonds, on the other hand, may come with a higher degree of credit risk. Even among corporate securities, the credit risk levels vary. You can rely on ratings by credit rating companies like CARE and CRISIL here. The higher the rating of the securities in a debt fund, the lower the credit risk. 

Interest Rate Risk

Remember how we discussed the effect of changing interest rates on the value of a security? If the interest rates fall, the value of a bond or security rises. Similarly, if the interest rates rise, the value falls. Interest rate risk is the probability that the value of a security may decrease due to interest rate fluctuations. 

Typically, gilt funds and corporate bond funds carry a fair bit of interest rate risk, but floater funds do not. This is because in securities with a floating rate of interest, the rate is regularly adjusted according to the benchmark rates. 

How to Invest in Debt Funds?

You can invest in debt mutual funds in any one of two ways, depending on your financial capacity -

Lump Sum Investment

Here, you can invest a lump sum of money in a debt mutual fund of your choice. This method is suitable if you have a large sum of money available, and want to invest it in a safe investment avenue. 

Systematic Investment Plan (SIP)

Here, you can invest small sums of money periodically in the debt funds of your choice. This is known as an SIP. This method is suitable if you do not have a large sum of money, but have a stable source of income. 

Summing Up 

This guide should give you clarity on what a debt fund is. Now that you know what these investment vehicles are and how they can benefit you, you may want to consider including them in your portfolio to reduce the overall risk. 

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Frequently Asked Questions 

1. What is a debt fund, and what is an example of such a fund?

A debt fund is a kind of mutual fund that invests in debt instruments and securities. Such instruments include government bonds, corporate bonds, money market instruments, and more. 

Examples of debt mutual funds include the Aditya Birla Sun Life Medium Term Fund, the Nippon India Ultra Short Duration Fund, the UTI Bond Fund, and the ICICI Prudential Ultra Short Term Fund, among others. 

2. What are debts in mutual funds?

Debts in the term ‘debt funds’ refers to the concept of the investor lending the money invested to the entity issuing the debt instruments. The capital you invest in a debt fund is a kind of loan that the bond or debt security issuer takes from you. So, these investments are called debt instruments, and mutual funds that invest in them are called debt mutual funds. 

3. Which is better: Fixed deposits or debt mutual funds?

Fixed deposits and debt funds come with their own advantages and benefits. The answer to which of these is a better option depends on your financial situation and goals. For instance, if you do not have a lump sum amount, you can start an SIP to invest in a debt fund. Debt funds may also offer you a higher return than traditional FDs.

4. Is it good to invest in debt mutual funds?

Investing in debt funds comes with many advantages. Your overall portfolio risk reduces, you can earn stable returns and you can even enjoy a good degree of liquidity. So, whether you are a conservative investor or a risk taker who wants to reduce your investment risk, debt funds make for a good choice of investment.

5. Is the Public Provident Fund a debt fund?

No, the Public Provident Fund (PPF) is not a debt mutual fund. It is a small savings scheme introduced by the government of India. That said, like debt funds, the PPF scheme also carries very low risk and offers guaranteed returns, making them suitable for any investor who is looking for low-risk investment avenues. 


Investment and securities are subject to market risks. Please read all the related documents carefully before investing. The contents of this article are for informational purposes only, and not to be taken as a recommendation to buy or sell securities, mutual funds, or any other financial products.
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