Short Answer – Of course yes.

What Are Debt Mutual Funds?

A debt mutual fund invests in various fixed interest bearing instruments, primarily government and corporate bonds, NCDs, preferential shares and cash equivalents. Just like a fixed deposit, these instruments pay interest to the bearer. The Government of India is the largest issuer of bonds and hence a majority of all debt investments are held by the Government.

A debt mutual fund earns money in 2 ways:

First, it earns interest on the instruments held by it.

Second, (this is what differentiates it from a fixed deposit) – debt mutual fund earns from change in prices of the bonds held by it. The price of a bond will change for many reasons, primarily because of changes in interest rates.

Consider a single bond – Once listed the price of bond will change based on buying and selling of the bond, just like it happens in case of equities.

Read MoreEquilibrium Price

Why would people buy and sell a bond which gives a fixed rate of interest?

Buying and selling activity in fixed income instruments depends on how much the instrument yields. How much a bond yields depends (amongst other things) on changes in interest rates. So if interest rates go up, bond prices will go down and if interest rates go down, bond prices will rise. To understand this, let’s consider the facts below:

Company A issues a bond with face value of Rs. 1000 with coupon rate of 8.5% p.a. (i.e. it pays 8.5% annualised interest) maturing in 2020. The coupon rate was set at a time when RBIs Repo Rate (i.e. the rate at which RBI lends to commercial banks) was at 7%.

2 days later, RBI cuts the Repo rate by 50 basis points to 6.5%. The effect this will have on new debt instruments will be that they will pay approximately 0.50% less interest (assuming they are of similar duration and risk profile).

Company B issues Bonds with similar risk profile and maturity date as Company A with face value of Rs 1000 after reduction of Repo Rate. Naturally, Company B will now offer coupon interest rate of ~ 8.0% on its bond. This in turn will make the old bonds of Company A far more attractive since they pay a higher rate of interest. If you calculate, over the next 2 years, Company A bonds will pay out Rs. 140 in interest payments while Company B bonds will only pay Rs. 130. For this reason the Face value of Company A bonds will rise from Rs. 1000 to Rs. 1010 to adjust for this interest differential.

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A word on Yield to Maturity

Yield to maturity is the total interest earned by an investor on a bond or any other fixed income instrument. It takes into account the current face value of the bond, and the coupon rate (which remains same). So in our example above, once the face value of Company A’s bond jumps to Rs. 1010, a new investor buying this bond will have a yield to maturity of 8.0%.

This is because while the coupon rate on Company A bonds will remain the same at 8.5%; since the new investor will be buying Rs. 1000 bond for Rs. 1010, his effective  yield will fall down to 8.0%. This is called yield to maturity.

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A Word of Caution

In debt markets, the face value or the price of bonds and other fixed income instruments moves not only when there is an actual change in interest rates but also when there is an anticipated change as also for a variety of other economic reasons.

Further, there is always a possibility of default where the issuer of the bond goes bankrupt. Typically, a debt mutual fund owns/ holds a number of instruments. There is always a possibility of one or more of these instruments defaulting which can bring down the price of a debt mutual fund.

Over the last 12-24 months in particular, much investment have been made in debt mutual funds. Many advisors and distributors have sold debt funds as replacement to Fixed Deposits. This is not right. Predictably then; over the past 6 months, most bond funds have delivered negative returns.

While Debt funds, chosen wisely will certainly deliver higher and more tax efficient returns, they carry higher risk than fixed deposits to a degree depending upon the fund and paper quality. Choose wisely!

Read More: Role of RBI in Indian Economy     |     Inflation and Interest Rates