First of all, let us tell you that debt funds are those mutual funds, which can generate returns by investing in fixed-income securities. Examples of fixed income securities are bonds and deposits of several types. This implies that their primary function is to lend money and gain interest against it. The interest earned forms the basis of returns generation for the investors.
It will be a good idea to look at the underlying securities, especially bonds, to have a better understanding of the debt funds. A bond is nothing but a certificate of deposit. A borrower issues this certificate to the lender. When individual investors set up a fixed deposit in a bank, he too does almost the same thing. When you are creating a fixed deposit in a bank, it implies that you are lending money to the bank.
Debt funds, too, do similar things. But there are few differences also. The first difference is that debt funds are capable of investing in several bonds. But an individual cannot do this. The greatest example is that the Government of India is the largest borrower and hence is the largest bond issuer too. The bonds issued by the Government of India cannot be purchased by individuals. Many media as well as large size businesses, too, issue bonds. Mutual funds can invest in these bonds. You can consider debt funds as a tool to pass on the interest income.
However, individuals tend to invest in FDs, while mutual funds prefer investing in bonds that are tradeable in the stock markets. Suppose a mutual fund invests in a bond and then the price of that bond rises, then the mutual fund will be able to achieve some extra income in addition to the interest income. Now this will be beneficial for the investors as they will enjoy higher returns. But it should be kept in mind that the reverse of the situation can also happen.
You might be thinking that why the bond prices keep on changing. There are several reasons for this. The most significant reason is the alteration in the rate of interest. Even the expectation of a change of interest rate can lead to alteration in the price of bonds. For instance, if there is a bond that pays out 9% interest per year, and in the meantime, the rate of interest in the economy sees a downfall, then newer bonds will pay out 8% interest per year. This will make the older bonds more valuable because it is capable of earning more money.
The price of these older bonds will shoot up. Investors too will be happy as they will be getting higher returns. The mutual funds, who will have these bonds, will realize that their holding is much more valuable now. They will be capable of earning more profits. But again, we will request you to keep in mind that the reverse situation is also possible. Hence, due to the rise in interest rates, the value of older bonds in possession of the mutual funds will decline. Thus the mutual funds can lose some of their money too.
In the end, we will say that debt funds are low-risk investments. Investors can expect this to be a safe game. But, always expect the unexpected. Keep in mind that the value of bonds can sometimes erode as well.