Debt funds are one of a number of fixed income investments.
A debt fund is an investment vehicle composed of fixed income debt instruments such as corporate or government bonds. Two essential elements on a corporation's balance sheet and a corporation's principal sources of funding are debt and equity. Equity refers to the value of shareholder stock, whereas debt refers to the amount of money borrowed by the corporation. While holders of equity are compensated according to a corporation's performance, holders of debt are compensated according to a fixed rate of return, which is predetermined at the issuance of the debt instrument. A debt fund may be composed of a number of debt instruments of varying levels of risk and interest rates.
Goals
Like an investment fund composed primarily of variable income instruments such as stock, a debt fund's goals are to preserve current wealth and increase that wealth over time. Due to economic forces such as inflation, uninvested wealth will decrease in value over time. Investing in a debt fund can help offset the impact of inflation and protect against a reduction of wealth in real terms. Additionally, a good debt fund can increase the value of an investor's assets beyond what is needed to keep up with inflation, and thereby create additional wealth.
Fixed Income
Unlike equity funds, debt funds are fixed income investments. This means that the rate of return on an investment is fixed at a certain level. For example, a 10 percent annual corporate bond has a fixed rate of return of 10 percent per year. While a stock's rate of return will vary according to the successes or failures of the underlying company, the rate of return on a bond will not.
Risk Premium
While the rate of return of a debt fund is fixed at a particular ceiling, there is always a risk that the company or government issuing the bond will default on its obligation to repay the lender, making the bond worthless. The likelihood of such a default is referred to as the riskiness of the bond. The higher the likelihood of default, the greater the risk and, therefore, the greater the rate of return that must be paid to lenders. This is referred to as the risk premium.
Secondary Markets
Large secondary markets exist for debt instruments. These are called secondary markets because the bonds are traded between individuals other than the company or government issuing the bond. Changes in the perceived risk of a particular bond or the prevailing interest rate in the broader market could make a bond more or less attractive than when it was originally purchased. In such circumstances, an investor may have an opportunity to realize a return on his investment greater than the fixed rate assigned to the bond.
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