When you park your money in a bank Fixed Deposit (FD), the bank promises to pay fixed interest in return. Here you’ve lent money to the bank, and the bank is a borrower of your money, owes you a fixed periodic interest. Debt Mutual Funds invest in debt securities like Government bonds, Company bonds, Money market securities. Bonds are issued by corporates like power companies, banks, home finance companies and the Government. These bond issuers promise to pay their investors (those who buy their bonds), a periodic interest in return for their money invested in the bonds.
Bond issuers are like the bank (borrower) in our FD example, borrowing money from investors and promising to pay periodic interest. While you are the investor in a bank FD, Debt Funds are the investors in these bonds. Just like you earn interest from an FD, Debt Funds earn periodic interests from their bond’s portfolio. Unlike assured interest from FDs, periodic interest payments to fixed income Debt Funds from these bonds can be fixed or variable without any guarantee. When they sell bonds from their portfolio, they get the principal back. When you invest in a Fixed Income Mutual Fund, you indirectly invest in its bond portfolio, spreading the risk across different bond issuers. You benefit from such risk diversification.