Article: Intro to Debt Funds

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What is a bond?

• Not James or covalent, but fixed-income instruments!
• It’s like a certificate of deposit or IOU
• Issued by the borrower to the lender
• Similar to setting up a fixed deposit in a bank
• When you make an FD with a bank, you are essentially lending money to the bank

Types

Corporate bonds, Government bonds, corporate debt securities

What is a debt fund?

• A fund that invests in bonds or other debt securities
• Can be contrasted with stock funds or money funds
• Usually pay periodic dividends that include interest payments on the fund’s underlying securities + periodic realized capital appreciation

Advantages:

• Relatively stable returns
• Relatively high liquidity
• Reasonable safety
• Low cost structure

Who should invest?

• Investors aiming for regular income
• Risk-averse folks - because they are less volatile and hence less risky than equity funds or stocks

How do debt funds work?

• They are similar to other mutual funds, but they lend money and earn interest on it
• Interest earned determines the basis for the returns generated for investors

Why debt funds?

• They are able to invest in many types of bonds that are not available to individuals
• For example, the Government of India, (largest borrower and bond issuer in the country) issues bonds which individuals cannot purchase
• Mutual funds also invest in bonds issued by large and medium-sized businesses
• The funds pass on the interest income they receive from the bonds they invest in

Notes:

Additional info on bond prices

Reasons for bond prices to rise or fall:

• Change in interest rates
• Expectation of change in interest rates!

Example:

If:

• A bond pays out interest at a rate of 9% p.a.
• Interest rate in the economy falls 

Then:

• Newer bonds start getting issued with a lower rate (e.g. 8% p.a.)
• Old bond would now be worth more than before
• Its price will accordingly rise 
• Investors will see the value of their investments go up

Implications:

Mutual funds that hold this bond will find their holdings worth more, allowing them to make additional profits by selling it.

The reverse is true as well. 

If interest rates rise, mutual funds holding older bonds would see the value of their investments fall and they could lose money.