Debt funds are getting a lot of attention these days. In recent years, this reasonably obscure sibling of equity funds has been in the news for various reasons. This ranges from Franklin Templeton freezing six of its debt funds with assets of Rs 28,000 crore to monthly net flows in debt mutual funds, doubling from Rs 43,431 crore in April to Rs 94,224 crore in May. For the typical investor, the obscurity surrounding debt funds continues to grow.
Fixed income products such as debt mutual funds and bank deposits are popular among investors who do not want to risk a portion of their investment to the whims of the stock market.
Over the last decade, debt mutual funds have grown in popularity among retail investors and high-net-worth individuals. Many investors are attracted to debt funds because of the potential for higher returns across various risk categories and the tax benefits of debt funds over bank deposits.
What are Debt funds?
A debt fund is a type of mutual fund that invests in debt instruments such as government and corporate bonds, money market instruments, and corporate debt securities, among other things. Debt funds are available in various risk-return profiles, investment horizons, and financial goals to accommodate investors with different risk-return profiles, financial goals, and investment horizons.
Treasury bills, commercial paper, government securities, certificates of deposits, securitized debt, money market instruments, and corporate bonds are all types of debt that debt funds invest in.
A debt fund and an equity fund invest in different asset classes, which is the main distinction. Equity funds invest at least 65 percent of their assets in stocks and stock-linked instruments, whereas debt funds primarily store bonds and cash.
Keep in mind that the value of an investment is determined by the values of the securities that make it up. Debt fund values are more secure than equity fund values because bond prices are less volatile than stock prices. On the other hand, debt funds are thought to be less dangerous, mainly when held for short periods.
4 situations when you should keep debt funds away
Secure the principal
If the preservation of your money is your primary priority in a debt investment, debt mutual funds aren’t for you. Unlike deposits or small savings accounts, debt mutual funds are market-linked entities that pass on to you not only interest but also capital gains or losses upon the bonds they own.
Some debt funds are particularly vulnerable to capital losses. This category includes funds that invest in longer-term government securities or bonds.
As interest rates rose between January 2009 and January 2010, gilt funds lost 12-13 percent of their NAV. Credit risk funds, which invest in lower-rated corporate bonds, can result in significant losses if the issuers whose bonds they hold default or are downgraded.
After large withdrawals from the money market pummeled bond prices, liquid funds, considered the safest, saw a brief spell of negative returns in March.
If you have a zero-tolerance for capital losses, you should avoid debt funds and instead invest in post office schemes or bank deposits.
Preserved Wealth
Have you gotten a large inheritance from a family or an employer that you’d like to keep? Are you a high-net-worth investor wishing to pass on your accumulated riches to future generations?
If safeguarding your wealth is more important than expanding it, you don’t need to risk capital losses or bond market volatility by investing in debt mutual funds.
Alternative debt investments with a capital guarantee, such as GOI 7.75 percent taxable bonds, Kisan Vikas Patra (6.9%), or National Savings Certificates (6.8%), that lock in your money for 5-9 years but promise to keep your capital intact, are available to such investors. The returns are also comparable to those of debt funds.
Zero Tax Considerations
One of the key arguments for investing in debt funds is tax efficiency.
Interest from bank FDs, GOI bonds, and post office schemes is considered income and taxed according to your tax bracket. Returns on debt funds’ growth options, on the other hand, are taxed as capital gains. This results in two tax benefits.
If you keep a debt fund for less than three years and use SWP to set up cash flows, you only pay tax on the ‘return’ portion of your withdrawals, not the total withdrawal amount.
Predictable Income
Some types of debt funds are more volatile than others. For example, gilt funds, which produced an 11 percent return in 2019, only earned 2% in 2017. After a slew of debt write-offs, credit risk funds, which astonished investors with 9-11 percent returns between 2011 and 2016, have posted a nil return in 2019.
Knowing which debt fund category will give a substantial return in the coming year necessitates making accurate estimates on changes in interest rates and companies’ capacity to service their debt. Even the best fund managers have struggled with this, so it’s a hard order for the average investor.
Yes, creating Systematic Withdrawal Plans (SWPs) to get consistent cash flows from debt funds can assist you in addressing this issue.
However, while SWPs smooth out your cash flows, they don’t change that debt fund returns are still erratic. Debt funds aren’t for you if you’re a pensioner, elderly citizen, or self-employed person searching for high-income dependability.
Conclusion
When choosing funds, keep the investment horizon in mind. For short tenors, such as 3-6 months, liquid or short-term funds with very little interest and credit risk are good options. Depending on risk appetite, one could invest in shorter-term categories (such as low-duration, short-duration, banks & PSU) or longer-term categories with some interest rate and/or credit risk.
