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Nowadays, due to low returns on bank fixed deposits (FD), many people are moving towards debt funds. Some debt funds show returns of 8% to 10%, hence people consider them to be a safe and better earning option. Debt fund is a type of mutual fund in which people’s money is not invested in the stock market but in bonds that are loaned to companies and the government.

If we understand in simple language, the fund house lends money to big companies or the government and earns interest in return. Investors get a part of the same interest as returns but not every company is safe, some companies are strong, so they raise money at lower interest. At the same time, the financial condition of some companies is weak or they have more debt than before. Such companies promise higher interest rates to investors so that people invest money in them.

This is the reason why some debt funds show higher returns than other funds, but behind higher returns there is also higher risk hidden. If the company is unable to return the money on time or its condition deteriorates, the fund may suffer losses. Its impact directly falls on investors. In the last few years, many such cases have come to light in India where debt fund investors suffered a major setback. Cases like Franklin Templeton, Infrastructure Leasing & Financial Services (IL&FS) and Dewan Housing Finance Limited (DHFL) have shown that debt funds are not completely safe. For this reason, market experts are now repeatedly advising people not to invest just after seeing high returns.

How does a debt fund work?

Debt funds invest people’s money in government bonds, corporate bonds and other fixed income schemes. Companies and the government pay fixed interest on these bonds. This is how the fund earns money. If the fund invests money in safe government bonds then the risk is considered less but if the fund invests money in weak companies then there can be more risk.

Debt funds that give high returns often invest in companies that the market does not consider completely safe. Such companies give higher interest to investors. For this reason, the returns of those funds also appear higher. According to SEBI rules, a credit risk fund has to invest at least 65% of its money in lower rated bonds. That means the risk in these funds is higher than before.

Investors have suffered losses before too

In the year 2020, Franklin Templeton had closed 6 of its debt funds. About Rs 26 thousand crores of investors were stuck in these funds. The company had said that there was a huge shortage of cash in the market and there was difficulty in selling the bonds. Apart from this, many debt funds were also affected during IL&FS and DHFL because the fund’s money was invested in the bonds of these companies. As the condition of the companies deteriorated, the value of many funds came down rapidly.

Increase in interest can also cause loss

The Reserve Bank of India (RBI) decides the repo rate from time to time. Repo rate is the interest price at which banks take loans from RBI. When RBI increases the repo rate to control inflation, both loans and interest become expensive in the market. This affects the old bonds; previously issued bonds start paying less interest while new bonds start paying higher interest. In such a situation, the demand for old bonds reduces and their prices start falling because the money of debt funds is invested in these bonds, hence the value of many debt funds may also fall.

Be careful before investing

Debt funds are not completely safe investments. With higher returns sometimes comes higher risk. Therefore, before investing money in any debt fund, it is important to understand where the fund is investing the money, how strong the company is and how much loss can be incurred in bad circumstances. Market experts believe that it is important to invest wisely in debt funds because here there is risk associated with earnings.