What You Need to Know About Debt Funds Before Investing
Overview and Investing Strategies for Debt Funds
Debt funds are pooled investments, such as mutual funds and exchange-traded funds (ETFs), that hold debt securities, such as bonds and other fixed-income instruments. Debt funds are typically used for income investing or as part of a diversified portfolio and can be purchased through mutual fund companies or brokerage firms.
How Debt Funds Work
Debt funds, also called bond funds or fixed income funds, typically invest in dozens or hundreds of debt securities in one pooled investment. This means that an investor can buy just one debt fund and potentially get exposure to many different types of bonds, such as corporate bonds, US Treasury bonds, municipal bonds, and foreign bonds. Investors may also choose a debt fund that focuses on just one of those categories.
When an investor buys a debt fund, they do not actually own the underlying debt securities but rather shares of the fund itself. With debt funds, the investor does indirectly participate in the interest paid by the underlying debt securities held in the mutual fund or ETF. Also, mutual funds are not valued by a price but rather a net asset value (NAV) of the underlying holdings in the portfolio.
How Debt Funds Are Different Than Bonds
Bonds are debt obligations issued by corporations, governments or municipalities. When you buy an individual bond, you are essentially lending your money to the entity for a stated period of time. In exchange for your purchase, the borrowing entity will pay you interest until the end of a specified term. The end of the term, which is called the maturity date, is when you will receive the original investment or loan amount (the principal).
Here are the primary differences between bonds and debt funds:
- Ownership: When you buy a bond, you are the owner of the debt security. With debt funds, whether they are mutual funds or ETFs, you don't hold the bonds; you own shares of the fund itself. The interest you earn, or what is called the yield of the fund, is a reflection of the combined average rates earned by the underlying bond holdings in the fund.
- Holding Period/Maturity: Once you buy a bond, you typically hold it until maturity. The period of time is usually at least three years and can be up to 30 years for some bonds. The price of the bond may fluctuate while you hold it but you will still receive 100 percent of your principal (original purchase amount) at maturity. However, with debt funds, you hold the fund as long as it suits your investment objectives. There is not a maturity date.
- Principal Risk: Prices for bonds and debt funds can fluctuate. However, since individual bonds are typically held until maturity, there is no real concern about price fluctuation. You don't ever "lose money" with a bond unless you sell it before it matures and the price has dropped (or the issuing entity goes bankrupt and has no money to pay its bondholders, which is extremely rare). However, you don't get your original investment back with a debt fund if it's worth less when you sell it that it was when you bought it.
Why Invest In Debt Funds
People who invest in debt funds are typically investors wanting to diversify their portfolio. Debt funds typically perform differently than equity funds, AKA stock funds. For example, during a bear market, when stock prices are falling, bond prices are often rising. For this reason, combining stock funds with debt funds reduces the volatility (ups and downs) of your account value.
Some investors buy debt funds as sources of income in retirement. The mutual fund or ETF will pass along the interest earned on the bond holdings to the investors. Debt funds typically pay quarterly dividends, which include interest payments. Debt fund investors also participate in gains in prices of the underlying debt securities.
How to Buy Debt Funds
You can buy individual bonds through investment advisors, stock brokers, or directly online with your own account through a no-load mutual fund company like Vanguard or Fidelity or a discount broker like Schwab or TD Ameritrade.
For more help on buying debt funds, see our article on how to choose the best bond funds.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.