Relatively few investors are aware of the existence of debt funds. When investors think about mutual funds, they generally assume that these funds make investments in the equity market. This is true most of the times. However, this is not true always. Of late, many specialized debt funds have come into existence.

In this article, we will have a look at some of the features of these debt funds and how they compare to the market at large.

Need For Debt Funds

Risk-averse investors park their funds in bank deposits. This is because bank deposits are safe and provide a guaranteed rate of return. However, bank deposits are not the only option that these investors have. Instead of lending to a bank which then lends the money to a corporation, individuals can directly lend their money to corporations via mutual funds. This enables them to earn a higher rate of return.

Debt funds are created by mutual fund companies who use the money to buy corporate bonds, commercial paper, and other such fixed-income assets. Let’s have a closer look at some of these advantages and disadvantages.

Advantages

The main advantages of using debt funds are as follows:

• Liquidity: Debt funds are highly liquid funds. This means that if today an investor decides to invest $100 for a 3 year period, he/she does not necessarily have to hold the investment through to maturity. After two months, they could decide that they want to sell the investment and could transfer it in the name of another willing buyer.

  This is not the case with bank accounts. If an investor wants their funds to be liquid, they have to open a savings account. The interest paid on a savings account is considerably less. On the other hand, if they want to earn higher returns, they have to choose a certificate of deposit. However, in this case, the liquidity is lost, and investors are forced to hold the investment until maturity.

  Hence, debt funds provide the advantage of both savings as well as a certificate of deposit. It provides the high returns associated with CD’s whereas it also provides the benefit of liquidity associated with savings accounts.

• Higher ROI: Banks are middlemen. They take funds from the investors and then pass them on to corporations at higher rates of returns. Bonds are a mechanism through which corporations can raise money directly in the capital market. This helps them bypass banks completely. Since the banks don’t have to be paid, corporations can afford to give higher rates of returns to investors. This is the reason why corporate deposits earn more interest when compared to bank deposits.
• Tax Treatment: As far as the taxation point of view is concerned, the rules may vary in every country. However, as a thumb rule, debt funds are more beneficial from a taxation point of view. This is truer if the fund is held for a long period of time. Interest earned on bank deposits is generally added to the income of the individual and taxed at a higher rate. However, income earned from certain kind of bank deposits is exempt from taxation. This is obviously not the case with corporate deposits.
• Diversification: Another great feature provided by debt funds is that they aid their investors in diversifying their money. If an investor directly invests in the bonds of certain companies, they have to take large exposure from one single company. The future of their portfolio then becomes completely dependent upon the future of that one company. This is where debt funds come into play. Even if an investor puts in $100, they can have exposure to several different companies. In this way, their portfolio is more protected from the downside.

Disadvantages

There are some disadvantages to investing in debt funds as well. This is the reason why many people still prefer bank deposits. Some of them are listed below.

• Safety Net: The biggest disadvantage of investing in bond funds is that there is no government-provided safety net. This is not the case with bank deposits. The government has collectively insured all bank accounts. Hence, even if the bank fails, the government promises to repay the investors’ money up to a certain amount. On the other hand, when investors place their hard earned money in the hands of any corporation, they have no recourse whatsoever. If the company fails to repay the debt, the government is not going to step in and make good the loss.
• Transaction Costs: It is true that debt funds provide a lot of liquidity. However, the liquidity is not free. Each time units of debt funds are bought and sold there are significant transaction costs. These costs may seem insignificant at first. However, they quickly add up, particularly when there is a significant amount of churn, i.e. rampant buying and selling in the investor’s portfolio.

To sum it up, debt funds provide another option for risk-averse investors. The risk that investors have to take is slightly more, but the returns also increase in proportion. Debt funds should be considered by an investor in order to balance their debt portfolio.