Income Generation from Debt Funds

Most of us understand how equity funds work. But how do debt funds generate returns?

First, it is important to dispel a common misconception with debts funds — that they cannot erode in value, just like fixed deposits. While debt funds are not as risky as equity mutual funds, a part of your initial investment can erode, nonetheless. This is because these funds invest in various fixed income instruments such as government bonds, corporate bonds and other money market and short-term debt instruments. The NAV on the debt fund can thus rise or fall along with the underlying bond prices.

And what impacts bond prices?

For one, interest rate movements in the economy can impact bond prices. If interest rates move up, bond prices fall and vice versa.

This is where the concept of ‘duration’ comes into play. As longer-duration bonds are more sensitive to interest rates, the fund manager of a debt fund will increase duration to cash in on the rally in bonds in a falling rate scenario.

Debt funds can also incur losses if they make wrong credit calls. Some debt funds capitalize on interest receipts. Thus they invest in bonds with lower credit ratings, betting on the credit risk to earn higher interest.

So, how can these funds suffer losses? If the company that has issued the bond defaults on its interest or principal repayment, then the debt fund’s portfolio, to that extent, is written off. This will impact the NAV of the debt mutual fund.

Hence, debt funds can follow a strict ‘duration’ or ‘credit’ call or blend the two to come out with different strategies.

For conservative investors

For those looking for alternatives to bank savings and fixed deposits, liquid funds and ultra short-term debt funds fit the bill. While these funds are riskier than bank FDs, they carry the lowest risk amongst debt funds.

While bank FDs for less than a year may offer returns comparable to those from liquid or ultra-short debt funds, should you need the money before maturity, you will be charged a penalty. Liquid funds allow you to exit investments without such penalties.

For moderate risk-takers

For investors with a slightly higher risk appetite and longer time horizon of, say, 2-3 years, debt funds, which generate returns both from accruals and duration calls (only moderately), may be considered. Short-term income funds and Banking and PSU Debt Funds fall under this category.

For high-risk takers

Investors willing to bet aggressively on either credit or interest rate movements can consider credit opportunities funds, regular income funds, dynamic income funds and long-term gilt funds.