While a lot of investors worry about investing in the equity markets especially because they are highly volatile in nature, they have the option of investing in debt funds. Debt funds may not offer returns as high as most equity mutual funds, but they have delivered stable returns with minimum investment risk. After crashing in March 2020, equity markets have gained momentum once again, and so have debt funds too. However, since the news surrounding fixed income securities concerns, a few people are planning on staying away from debt mutual funds.
Debt funds are a good investment product. They take minimum investment risk, invest in fixed income securities and debt-related instruments like commercial paper, government bonds, certificate of deposits, treasury bills, cash and cash equivalents, CBLO, reserve repo, etc. Investors enjoy tax benefits over fixed deposits – i.e. the benefit of long-term capital gains (LTCG) with indexation (over 3 years), with borderline tax. They offer high liquidity and investors usually consider debt funds to diversify their equity-heavy portfolio. Investors consider liquid funds for parking their surplus for the short term or for building an emergency fund as they can immediately redeem their units and receive an equivalent sum in their savings account.
While considering debt funds investors should understand that just like equity funds they aren’t risk-free either. Debt mutual funds invest in fixed income securities that are prone to credit risk and interest rate risk. A change in interest rates affects bond prices. Here, debt instruments with a short maturity are less likely to get affected by the fluctuations in the interest rate. Schemes like liquid funds and overnight funds have less interest rate risk as the average maturity of their portfolio is quite short. On the other hand, medium and long-duration funds are more prone to risk as their average maturity portfolio is long. Credit risk arises when the borrowers are low grade and when they fail to return the lent money on time. However, investments in a debt fund with a high credit risk may be able to have a higher yield than other debt funds. While choosing a debt fund with high credit risk, investors must ensure that the investment portfolio of the scheme is well diversified.
The reason why most people invest in debt funds is despite their ability to not fetch higher returns in just one. They are a lot safer than other mutual fund schemes. Investors can mitigate their investment risk by investing in the right mix of debt funds. Investors with a short-term investment horizon can consider investing low duration funds, ultra short-term funds, or liquid funds. On the other hand, investors with a long-term investment horizon can consider a debt fund whose average maturity matches their long-term income needs.
Irrespective of which basket of debt funds investors invest in, they should always do a thorough background check on the fund’s performance. Although it is true that a debt fund scheme’s past performance cannot determine its current or future performance, a debt fund that has been consistent with delivering stable returns speaks volumes of the fund management under which it is. Investors should try and understand which debt category suits best for their financial goals and they can invest accordingly. They can even start a SIP in debt funds which will allow them to invest small fixed sums periodically and build a sizable corpus in the long run. They can even use the SIP calculator, a free online tool to help them determine the total returns from their SIP investments in debt funds.