What Are Debt Funds?
August 30, 2019
A debt fund is a pool of money that is used to provide borrowing funds to entities like governments, banks, & limited companies and the money invested in a debt fund earns a fixed rate of return.
Broadly, funds are of two types – equity and debt funds. An equity fund invests its money in the shares of a company and the shares earn a portion of the profits earned by the company, in the form of dividends. If a company incurs a loss, the equity investors will not see a return on their investment for that year. A debt fund makes money available as a loan to different entities. When an entity borrows money on a debt instrument, it is obligated to pay the amount of interest promised, irrespective of how it performs and whether it earns a profit or loss.
Debt funds are, in general, low risk instruments because the borrowers will necessarily pay out the interest. At the same time, the rate of return is considerably higher than fixed deposits with banks.
Even banks, the same ones you take fixed deposits in, offer another product called “certificates of deposit”. Certificates of deposit earn a higher return than fixed deposits. The problem for a layman is that a certificate of deposit would be only to a tune of something like 500 crores. You can open a fixed deposit for a few thousand rupees but as an individual where will you go for 500 crores? Instead, invest in a debt fund that invests in these certificates. The mutual fund pools the money of many people and every one of those with a unit in that debt fund are going to see a higher rate of return! The risk is low because at the end of the day, you are entrusting your money to the same banks you would have opened your FD in. In fact, the risk might be even lower than with an FD because your FD is in one single bank but your fund might have invested in multiple banks.
This is just an example of mutual funds that invest in CDs. There are all kinds of debt funds – ones that invest with central and state government, with banks, and with public limited companies.
