Debt funds are a type of mutual fund that generate returns from their investors' money by investing in bonds or deposits of various kinds. These terms basically mean that they lend money and earn interest on the money they have lent. This interest that they earn forms the basis for the returns that they generate for investors.
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 do something as simple as make a fixed deposit in a bank. When you make an FD with a bank, you are basically lending money to the bank. You can also buy bonds, for example the tax-rebate bonds issued by various companies like REC and HUDCO.
This is exactly what debt funds do, except for a few differences. One, they are able to invest in many types of bonds that are not available to individuals. For example, the Government of India issues bonds. It is in fact, by far the largest borrower (and thus bond-issuer) in the country. Bonds are also issued by many large and medium sized businesses in the country. Mutual funds also invest in these.
A simple way of understanding debt funds is to think of them simply as a way of passing through the interest income that they receive from the bonds they invest in. There are a couple of further complexities to this.
One, unlike the FDs that individuals invest in, mutual funds invest in bonds that are tradable, just like shares are tradable. The way there's a stock market where shares are traded, there's also a debt market where bonds of various types are traded.
Two, on this debt market, the prices of different bonds can rise or fall, just like they do on the stock markets. If a mutual fund buys a bond and its price subsequently rises, then it can make additional money over and above what it would have made out of the interest income alone. 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 first appeared in June 2013.