Debt Funds invest our money in interest-bearing securities like bonds and money market instruments that promise to pay regular interest. These interest payments are received by the fund which in turn contributes to the total return we, as investors of the fund, earn. When the interest rates change in the market, prices of fixed income securities like bonds and money market instruments also change but in the opposite direction. When interest rates rise, prices of these assets fall and vice-versa. Thus, NAVs of Debt Funds change with change in prices of these securities. Changes in NAV impact the total return generated by these funds.
Other than interest rate changes, changes in the credit rating of bonds can impact returns from debt funds. Credit ratings signify the creditworthiness of bond issuers. A downgrade in rating will lower the prices of these bonds. This, in turn, will cause downward pressure on NAVs of funds holding these bonds. Thus, a credit downgrade of bonds held in the portfolio of a Deb Fund can lower your returns.
Increase in default risk or the chances of bond issuer failing to pay interest or return principal adversely affects returns from Debt Funds since the interest payments add to your total return from Debt Funds since the interest payments add to your total return from the fund.
