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Should you invest in debt funds now?

Jagrity Sharma Jagrity Sharma 27 August 2019

Debt mutual funds’ performance have been quite disappointing in the past few months. Should you still have a place for debt mutual fund in your investment portfolio?

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Debt mutual funds have hit a rough patch recently, and their NAV (Net Asset Value) have seen some depreciation. Many of you who have debt fund in your mutual fund portfolio may be wondering if you should remain invested in debt fund of your investments. Others, who have heard that debt fund is less risky than an equity fund, may think that debt fund is best avoided.

There is, however, no reason to panic as this is not the first-time mutual fund has been through a crisis. Let's first understand why you need fixed income investment instruments in the first place? Simply because they offer much safety. It provides stability to your investments and should have a place in your asset allocation. Even for first-time investors, it is advisable to start investing in an aggressive hybrid fund as the 35% allocation to debt instruments provides stability to your investment.

Fixed income investments are of several types. Most Indians prefer to invest in bank FDs and Public Provident Fund. However, the problem with such schemes is that they are not tax-efficient, and they provide less liquidity. Also, as compared to a mutual fund, they also offer low returns. This is where the debt fund has an advantage. They offer tax efficiency, liquidity and a higher rate of returns. Debt mutual fund gives place to the fixed income in your investment portfolio. However, you need to be cautious. The recent downfall experienced by debt funds should not be the reason to avoid them altogether.

How should you go about investing in debt fund?

It is essential to understand the risk element first. Many investors may get carried away by chasing past performance. They simply pay attention to the extraordinary returns given by the fund in recent times and try them out. That is where you take a risk! Debt mutual fund can turn around when it is least expected. The first rule of investing in debt mutual fund is that do not chase the past performance. Secondly, stay away from the exotic debt fund category. Debt fund categories are quite complicated. SEBI has defined 16 open-ended debt fund categories. If you want to invest your money for a few weeks or months, it is advisable not to look beyond liquid funds.

Who should invest in debt mutual funds?

Debt mutual fund is ideal for those who are risk-averse and not ready to include equity exposure in their investment portfolio. Debt funds help you grow your funds with little or sometimes, no risk. Additionally, they can be a good source for regular income as well. You should stay invested in debt funds for short to medium term to gain the desired returns. It is vital to choose an appropriate debt mutual fund as per your investment horizon.

Liquid debt funds are generally suitable for short-term investors who usually keep surplus funds in the savings account. Liquid funds provide returns generally in the range of 7% to 9% in addition to the withdrawal facility at any time, just like a savings bank account. If you are ready to ride the interest rate volatility, then dynamic bond funds may be an ideal option for you. These funds are suitable for investors who want to invest for medium-term to earn comparatively higher returns than a five-year bank fixed deposit.

Things to consider while investing in debt fund

  • Fund objectives: Debt funds usually aim to earn optimal returns by maintaining a diversified portfolio of different types of securities. You can expect debt mutual fund to perform predictably as they are generally accessible among conservative investors.
  • Fund category: Debt funds are classified into different categories such as liquid funds, fixed maturity plans, monthly income plans, dynamic bond funds, credit opportunities funds, income funds, GILT funds, and short-term funds. It is vital to invest in a category that is suitable for you.
  • Risks involved: Debt funds are not entirely risk-free. They are prone to credit risk, interest rate risk and liquidity risk. Your investment value may fluctuate due to the movement in the overall interest rates. Additionally, there is a risk of default in the payment of principal and interest by the issuer. Liquidity risk may arise when the fund manager is unable to sell the underlying security due to lack of demand.
  • Cost of investing: Fund house charges an expense ratio to manage your mutual fund investment. However, SEBI has mandated the upper limit for such ratio to be 1.05%.
  • Investment horizon: Investment term for liquid funds is ideally three months to 1 year. If you want to stay invested for a longer-term, then you can explore short-term bond funds.

How to evaluate the best debt mutual fund?

You can choose the best debt mutual fund by evaluating it with the parameters listed below:

  • Fund returns: Choose the funds which have outperformed their benchmark consistently across different time frames. However, do not forget to analyse the fund performance, which matches your investment term to get desired returns.

  • Fund History: Choose the mutual fund house that has a strong history of consistent performance in the investment domain at least for five to ten years.

  • Expense ratio: An expense ratio indicates how much of your investment goes towards managing the mutual fund. Lower the expense ratio, better will be your take-home returns.

  • Financial ratio: You can use different financial ratios such as sharpe ratio, beta, the standard deviation to analyse the fund. A mutual fund having higher standard deviation and beta is riskier than the one with lower standard deviation and beta. Look for funds that have a higher sharpe ratio. It indicates that the fund gives higher returns on each additional unit of risk taken.

Remember that debt mutual fund is exposed to both interest rate risk and credit risk. A recent downturn has led to many investors falling in doubt whether to invest in debt funds or not. Every business, every sector passes through a cycle. Hence, stay put, invest sensibly, and do not panic. Perform your due diligence and pass through the current crisis. There is no reason to panic. The current debt fund crisis is primarily confined to defaults among some non-banking finance companies, and within that, not all have been affected.

Recommended Read: When Should I Change My Existing Mutual Fund Scheme?

Jagrity Sharma
Written by Jagrity Sharma
A bibliophile who hates alliterations, but loves cream, comics and content immensely! On another note, a content marketer who leverages the power of words to explain...almost anything!