Debt Fund Definition, Risk, How to Invest, Examples

What Is a Debt Fund

A debt fund is an investment pool, such as a mutual fund or exchange-traded fund, in which the core holdings comprise fixed income investments. A debt fund may invest in short-term or long-term bonds, securitized products, money market instruments or floating rate debt. On average, the fee ratios on debt funds are lower than those attached to equity funds because the overall management costs are lower.

Often referred to as credit funds or fixed income funds, debt funds fall under the fixed income asset category. These low-risk vehicles are customarily sought by investors looking to preserve capital and/or achieve low-risk income distributions.

Debt Fund Risk

Debt funds may invest in a wide swath of securities, with varying associated risk levels. U.S. government debt is generally considered to pose the least risk. The risk profile of corporate debt issued by businesses as part of their capital structures is generally classified by the company’s credit rating.

Investment-grade debt is issued by companies with stable outlooks and high credit quality. High-yield debt, which is mainly issued by lower credit quality companies with potential emerging growth prospects, offers higher returns, along with higher prospective risk. Other debt categories include developed market debt and emerging market debt.

Debt Fund Investing

Investors may choose from a wide range of low-risk debt fund options, in both passive and active products.

Passive

Some of the largest and most actively-traded passive fixed income investment funds seek to replicate the top fixed income benchmark indexes, including the Bloomberg U.S. Aggregate Bond Index and the ICE U.S. Treasury Core Bond Index. Passive ETFs replicating these indexes include:

iShares Core U.S. Aggregate Bond ETF

The iShares Core U.S. Aggregate Bond ETF (AGG) is a passively managed index replication fund that tracks the Bloomberg U.S. Aggregate Bond Index. The fund has a net expense ratio of 0.03%. Its 5-year average annual return as of Aug. 4, 2022 is 0.83%.

iShares U.S. Treasury Bond ETF

The iShares U.S. Treasury Bond ETF (GOVT) is a passively managed index replication fund that tracks the ICE U.S. Treasury Core Bond Index. It has a net expense ratio of 0.05%, and its 5-year average annual return through Aug. 4, 2022, is 0.61%.

Active

The debt fund market also includes a wide range of active managers, who seek to outperform debt fund indexes such as the Bloomberg U.S. Aggregate Bond Index and the ICE U.S. Treasury Core Bond Index.

The First Trust Tactical High Yield ETF (HYLS) is an example of an actively-managed debt fund that invests for income and capital appreciation. Its 5-year NAV return as of Aug. 4, 2022, is 0.89%. While the fund is not outperforming its selected index year-to-date, it is one of the top-performing funds in the U.S. high yield bond universe.

Overall, investors in debt funds should understand the return calculation measurements that are used as performance indicators. Since debt funds involve income generation, funds may pay scheduled monthly or quarterly dividends. Total return calculations account for income payouts, while general return calculations may not.

Global Debt Funds

Countries issue debt in various forms to support their governmental fiscal policies. In the U.S., government-issued debt is generally considered to be the lowest risk fixed income investment in the market.

U.S. Debt Funds

The U.S. government issues a wide range of securities for investment. These securities can be invested directly, or investors may choose to invest in diversified debt funds that include these securities. BlackRock’s iShares is one of the market’s leading managers for indexed U.S. government debt fund ETFs.

U.S. corporate debt funds are typically segregated by the credit quality of the corporate issuer. U.S. companies have some of the highest credit ratings globally, placing U.S. debt funds in high demand.

Global Debt Funds

Many countries offer debt investments to support government fiscal policies. Risks and returns of government debt funds vary, depending on a nation's political and economic environment. Similar to equities, global corporate bond funds can be segregated by developed and emerging market indexes. Credit ratings are assigned to both government bonds and corporate bonds, using globally standardized credit rating analysis.