Debunking myths about Debt Mutual Funds

Debunking myths about Debt Mutual Funds

24 Dec 2018

Introduction to Debt Mutual Funds

Buying a debt instrument is similar to giving a loan to the issuing entity. The basic reason behind investing in debt funds is to earn interest income and capital appreciation on your investment. The interest that you earn on these debt securities is pre-decided or fixed along with the duration after which the debt security will mature.

This is the reason as to why these securities are called 'Fixed-Income' securities because you know what you're going to get out of them. Debt funds try to optimize returns by diversifying across different types of securities. This allows debt funds to earn decent returns, but there is no guarantee of such returns.

Who should invest in a debt mutual fund?

Debt mutual funds are ideal investments for conservative investors. They are suitable for both short-term and medium-term investment horizons. Short-term starts from 3 months upto 1 year. Medium term is generally between 3 years to 5 years.

  • For a short-term investor, debt funds like liquid funds may be an ideal investment as compared to keeping your money idle in a savings bank account. Liquid funds offer the scope for earning comparatively higher returns in the range of 7%-9% along with similar kind of liquidity for meeting emergency requirements.
  • For a medium-term investor, debt funds like dynamic bond funds can be ideal to ride the interest rate volatility. As compared to 5-year bank FD's, these bond funds offer higher returns.
  • If you want to earn regular income from your investments, then Monthly Income Plans (MIP) may be a good option to consider.

Myths about Debt Mutual Funds

Debt funds can give negative returns and are therefore are not risk free at all as is a popular perception. They are meant for common retail investors like you and me. You should always consider debt funds as a part of your investment portfolio. Understanding them and not basing your decision on perception is crucial. Following are some common misconceptions which you should guard yourself against:

  • Debt Funds are Risk Free – Be it equity or debt, no market related investment can be considered as absolutely risk free. Interest rate risk and credit risk are two prime risks in a debt instrument. The interest rate risk refers to a change in the price of a bond due to the change in the prevailing interest rates. The bond prices rise as the interest rates fall and vice- versa. The credit-worthiness of the issuer of paper viz., either a financial institution or corporate, is termed as Credit risk. Liquidity risk is another type of risk to which debt funds are exposed to.
  • Debt Funds will never give negative returns – Investors believe that there cannot be negative returns from a liquid fund. The maturity period of instruments in such a portfolio is less than 91 days and thus the interest rate risk does not exist to the tune it does in other debt funds, but it exists nevertheless. However, it is also to be noted that the fund managers tend to stick to a high credit rating to maintain a very high quality portfolio which makes it less susceptible to default risk.
  • Debt Funds are only for Institutions – Investors balance their overall investment portfolio with debt funds. Even if allocation to debt is miniscule, some degree of allocation is always advisable. Debt funds help an investor diversify his / her portfolio into a different asset class.

To conclude, we can say that returns from debt fund returns can be expected in a more or less predictable range, which make them relatively safer avenues for conservative investors. Debt funds invest in different securities based on their credit ratings. A security's credit rating signifies whether the issuer will default in making the promised payments. The fund manager of a debt fund ensures that he invests in high credit quality instruments. A higher credit rating means that the entity is more likely to pay interest on the debt security regularly as well as pay back the principal amount upon maturity.

This is why debt funds, which invest in higher-rated securities, will be comparatively less volatile as compared to lower-rated securities. Additionally, the maturity also depends on the investment strategy of the fund manager and the overall interest rate regime in the economy. A falling interest rate regime encourages the manager to invest in long-term securities. Conversely, a rising interest rate regime encourages him to invest in short-term securities. General investors should take care of these aspects before investing into these funds to avoid disappointments or setbacks.

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