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Understanding the basics of debt investment

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If investing in debt mutual funds is in your financial planning, then you need to have a basic understanding of how debt funds work and a few things about these fixed income oriented schemes before investing.

The three most basic things to keep in mind when investing in debt funds is the entity borrowing the money, the tenure of the loaned amount, and the potential returns which one can earn from investing in that debt fund.

The entity borrowing the sum – Assessing the creditworthiness of the entity borrower is necessary so that investors have a clear idea of whether the entity borrowing the sum has the ability to repay within the pre-defined tenure. To understand the credibility of the borrower, they are given credit ratings such as AAA, AAA+, etc. which gives people a fair idea about their worth. The higher the credit score, the more reliable the creditor is in terms of repaying the debt.

The loan duration – Now if and when you take a loan from a bank, it makes it mandatory that you return the amount in EMI or lumpsum before a fixed duration. Similarly, investors must be aware when the creditor is going to repay the money in whose issued bonds have been invested. The date of maturity must be clear as investors have every right to know on which date the borrower will be repaying the money loaned from them.

Understanding potential returns – If and when you are investing in a conventional fixed income instrument, the first thing that you check is the interest rate that the scheme is offering. Then why not do the same when investing in debt funds? You may know for a fact that debt mutual funds predominantly invest in fixed income securities and money market instruments to generate returns. However, debt funds do not guarantee returns. Having said that, the returns from debt funds are not guaranteed but based on their past performance, investors should be able to get a fair idea about the kind of returns that particular debt scheme is offering.

Investors consider debt funds either for diversification or because they do not want to expose their finances to the dangers of volatile equity markets. Debt fund investors are always concerned about their invested capital but at the same time, they too expect some returns from their investments.

Types of debt funds

Market regulator SEBI currently has 16 different product categories under debt funds. They are –

  1. Liquid Fund
  2. Overnight Fund
  3. Money Market Fund
  4. Gilt Fund
  5. Long Duration Fund
  6. Floater Fund
  7. Ultra Short Fund
  8. Medium Duration Fund
  9. Credit Risk Fund
  10. Dynamic Bond Fund
  11. Medium to Long Duration Fund
  12. Corporate Bond Fund
  13. Banking and PSU Fund
  14. Gilt Fund with 10 year constant Duration
  15. Short Duration Fund
  16. Low Duration Fund

Debt funds offer liquidity which other mutual schemes like ELSS (Equity Linked Savings Scheme) lack. A mutual fund portfolio must have liquidity so that the investor is able to immediately redeem some of their investments in case of a financial emergency. Also, returns from debt funds remain unaffected by the upheavals in the stock market and they try to generate stable returns while protecting the investor’s capital. Depending on your investment horizon and income needs, you can either consider debt funds with low maturity duration, short term maturity, or those whose portfolio matures over the long term. Also, investors can start a SIP in debt funds to ensure that they save and invest a fixed sum periodically.

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