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Debt funds are mutual funds that generate returns by investing in fixed income securities, that is in bonds or deposits of various kinds. This means that they lend money and earn interest on it. The interest that they earn determines the basis for the returns that they generate for investors.
To better understand debt funds, let's have a look at their underlying securities, mainly bonds. A bond is like a certificate of deposit that is issued by the borrower to the lender. Individual investors do something very similar when they set up a fixed deposit in a bank. When you make an FD with a bank, you are basically lending money to the bank.
This is exactly what debt funds do, except for a few differences. For one, they are able to invest in many types of bonds that are not available to individuals. For example, the Government of India, which is by far the largest borrower (and thus bond issuer) in the country, issues bonds which individuals cannot purchase. Bonds are also issued by many large and medium-sized businesses in the country, which mutual funds may invest in. Think of debt funds as a means to pass on the interest income that they receive from the bonds they invest in.
However, unlike the FDs that individuals invest in, mutual funds invest in bonds that are tradable in the debt market, just like shares are tradable in the stock market. In this debt market, the prices of different bonds can rise or fall, just like they do in 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 returns for investors. Obviously, the reverse is also true.
But why would bond prices rise or fall? There can be a number of reasons. The most important one is a change in interest rates, or even the expectation of such a change. Let us suppose there's a bond that pays out interest at a rate of 9 per cent a year, and the interest rate in the economy falls so that newer bonds start getting issued with a lower rate of say, 8 per cent a year. Obviously, the old bond would now be worth more than earlier. After all, a given amount of money invested in it can earn more money. Its price will accordingly rise and investors will see the value of their investments go up. Mutual funds that hold this bond will find their holdings worth more, allowing them to make additional profits by selling it. Again, obviously the reverse is true as well. So if interest rates rise, then mutual funds that are holding older bonds would see the value of their investments fall and they could lose money.
So while debt funds are typically treated as a low-risk investment (which in fact they are) and investors expect a certain level of safety, there is a chance that even a bond fund may see its value erode.
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