How debt mutual funds work

Debt mutual are a type of mutual fund that generate returns from their investors' money by investing in bonds or deposits of various kinds. In short, they lend money and earn interest on the money they have lent. This interest that they earn forms the basis for the returns that debt funds generate for investors.

What is a bond, one might wonder? A bond is like a certificate of deposit that is issued by the borrower to the lender. Even individual investors do something similar when they make a fixed deposit in a bank. When you make an FD with a bank, you are basically lending money to the bank and you earn interest on it. You can also buy certain bonds directly, for example the tax-rebate bonds issued by various companies like REC and HUDCO. In fact, with RBI's Retail Direct portal launched in November 2021, you can invest in government securities also directly.

This is exactly what debt funds do, except for a few differences. For instance, they are able to invest in many types of bonds that are not available to individuals such as bonds issued by many large and medium sized businesses in the country. Thus, it is possible to easily diversify fixed income investments through debt mutual funds.

Further, unlike FDs that individuals invest in, mutual funds invest in bonds that are tradable, just like shares. The way there's a stock market where shares are traded, there's also a debt market where bonds of various types are traded. The prices of different bonds can rise or fall due to various factors as explained below. But owing to this fluctuation, a mutual fund can make additional money over and above what it would have made out of the interest income alone if it buys a bond and its price subsequently rises. This would result in higher return for investors. Obviously, the opposite is also true.

But why would bond prices rise or fall? There can be a number of reasons. The major one is a change in interest rates, or even the expectation of such a change. Suppose there's a bond that pays out interest at a rate of 9 per cent a year. Then, the interest rates in the economy fall and newer bonds start getting issued at 8 per cent. Obviously, the old bond should now be worth more than earlier. After all, a given amount of money invested in it can earn more money. Its price would now rise. Mutual funds that hold it would find their holdings worth more and they could make additional profits by selling this bond. Again, the reverse could happen when interest rates rise. Despite the expectation of safety, such a situation could actually result in some losses for a bond fund.

This article was originally published on March 03, 2022, and last updated on September 23, 2022.