What Is a Debt Fund?

Debt funds are pooled investments, such as mutual funds and exchange-traded funds (ETFs), that hold debt securities like bonds. Debt funds are typically used for income investing or as part of a diversified portfolio. They can be purchased through mutual fund companies or brokerage firms.

Keep reading to learn about how you can add debt funds to your brokerage account, and why an investor might choose to do so.

Definition and Examples of a Debt Fund

Debt funds are similar investment products to any other fund, such as an S&P 500 ETF or a Fidelity mutual fund. Investors pool together funds, and the fund manager uses those funds to buy and sell investments held within the fund. The only difference between a debt fund and an S&P 500 ETF is in the type of investments held within the fund—an S&P 500 ETF holds stocks, while a debt fund holds debt.

Different debt funds may focus on different types of debt. Well-diversified debt funds, for example, give investors exposure to many different types of debt, such as corporate bonds, U.S. Treasury bonds, municipal bonds, and foreign bonds. Investors may also choose a debt fund that focuses on just one of those categories.

• Alternative names: Bond funds, income funds, fixed-income funds

How Debt Funds Work

Debt funds are traded just like any other mutual fund or ETF. 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.

Debt Funds vs. Individual 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 are paid, 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 can be as short as a few months or as long as 30 years. The price of the bond may fluctuate while you hold it, but you will still receive 100% 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 no 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 usually "lose money" with a bond unless you sell it before it matures and the price has dropped. The only exception is when the debt-issuing entity goes bankrupt, but when it comes to bonds issued by the U.S. government or major corporations, default is extremely unlikely.

However, if the price of a debt fund drops after you buy it, there's no guarantee that you'll get your original investment back. There isn't a set maturity date when the fund will restore its principal value. Instead, the value will fluctuate based on the fund's holdings in perpetuity.

What It Means for Individual Investors

People who invest in debt funds are typically investors who want to diversify their portfolios. Debt funds typically perform differently from equity funds like a stock ETF. If stock prices fall on a given day, bond prices might not fall as much, or they might even rise. 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 any interest payments earned throughout the quarter. Other debt funds pass along interest payments in the form of dividends every month.

How to Buy Debt Funds

You can buy bonds and bond funds through investment advisors, stockbrokers, or online no-load mutual fund companies like Vanguard or Fidelity and discount brokers like Schwab or TD Ameritrade.