What Are Debt Mutual Funds And Why You Need These In Your Portfolio

Over the past few decades, mutual funds have been increasingly becoming one of the preferred investment instruments for people to achieve their life goals and maximize the potential of wealth creation. This is largely because the diverse categories in mutual funds have something to offer for every investment horizon and for every type of investor, whether a risk taker. a risk averse investor or someone with a mix of both. Besides the immensely popular category of mutual funds-Equity, which remains a favorite and go to asset class for those having high risk appetite and/or aiming for high returns, especially the millennials, a relatively lesser talked about category of mutual funds which holds the potential to cater to the low-risk taking investors, is debt funds. Given that low risk takers and risk averse investors tend to stick to traditional investment instruments like FDs, PPF, NPS, etc. which offer sub-optimal returns, opting for debt funds can turn out to be a smart move for them. Even for existing equity investors, sliding in a level of diversification into their portfolio through debt investments can ensure they do not end up putting all their eggs in one basket.

Nevertheless, since the two driving factors behind the whole gamut of investment portfolio are the risks and returns associated with the instrument, having debt funds in your mutual fund portfolio can certainly give it the optimal balance irrespective of the proportion of equity in the portfolio.

Let us move forward towards understanding debt mutual funds, their importance/relevance, and what investors should factor in when investing in them:

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What are Debt Mutual Funds?

Debt funds are a type of mutual funds that invest in fixed income securities such as corporate bonds, treasury bills, commercial papers, government securities, and numerous other money market instruments. Each of these instruments involve a pre-decided maturity date as well as interest rate which the investor can earn on maturity. As the returns of these securities are generally not impacted by the market fluctuations, they are much less volatile than equities, thereby making debt securities a suitable investment option for risk averse investors.

Key Features of Debt mutual funds:

1. Capital protection

Debt funds do not offer any capital protection. As the underlying securities being traded in debt markets are vulnerable to market¡¯s fluctuations, they can be exposed to capital erosion. Primarily, the two main risks faced by debt fund investors are interest rate risk and credit risk. Interest rate risk is when the investment in underlying debt funds gets impacted by the unexpected changes in the RBI¡¯s interest rate. One can mitigate this risk by opting for short term debt funds having lower maturity, such as liquid funds or ultra-short term funds.

On the other hand, credit risk of debt funds is the risk arising due to a default in interest or principal repayment by the underlying securities¡¯ issuers. This risk can be minimized by opting for the debt funds that invest in instruments having high credit rating, as they involve lower risk of default.

2. Returns

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Returns generated by debt funds primarily depend on the interest income earned and the capital gains garnered from the underlying securities. Credit ratings of underlying securities, assigned by agencies like CRISIL, CARE and ICRA, also play a crucial role in deciding the interest income. The low rated securities tend to usually yield higher interest income but involve larger risk, vis-a-vis the high rated ones which involve lower risk. Therefore, before choosing between long term and short-term debt funds, carefully analyse the current interest rate regime and credit rating of the underlying securities.

As per valueresearch data for returns dated 09.09.2021, the category average returns of some of the categories of debt funds, are:

Liquid Funds-3.29% for 1 year, 5.02% for 3 year and 5.80% p.a. for 5 year period.

Low duration Funds-4.93% for 1 year, 5.18% for 3 year and 5.97% p.a. for 5 year period.

Short duration Funds-5.73% for 1 year,7.14% for 3 year period and 6.94% p.a. for 5 year period.

Long duration Funds-4.81% for 1 year ,11.53% for 3 year and 8.29% p.a. for 5 year period.

3. Taxation

For debt funds, the returns booked on redeeming your investment within 3 years are considered as short-term capital gains, which is included in your annual income and taxed in accordance with your income tax slab. Whereas, the returns booked on investments after 3 years are considered as long-term capital gains and get taxed at 20% with indexation benefits.

4. Premature withdrawal

In debt mutual fund, only the fixed maturity plan (FMP) restricts redemption while other categories allow withdrawal by paying a minimal exit load if redeemed before a predetermined period. However, ultra short funds, liquid funds and most short-duration debt funds currently do not levy any exit load. Thus, the presence of high degree of liquidity is what makes these funds a prudent option for parking money for emergency fund and short-term goals.

5. Cost of Investment

For operating your debt mutual fund schemes, mutual fund houses charge multiple fees such as advisory and management fees, audit and legal fees, sales and agent commissions, marketing and selling expenses etc. These charges are expressed in the form of total expense ratio (TER). This ratio is derived by dividing the fund¡¯s total expenses by the total assets of the fund. A smart way for investors to mitigate this expense is by opting for direct plans of debt funds, instead of their regular counterparts, as the TER of direct plans is usually lower than the regular plans.

Who should invest in Debt Funds?

While there is no hard and fast rule or guide depicting who should invest in which type of mutual fund or any other investment instrument, it¡¯s usually advisable for risk averse investors to opt for debt mutual funds. Given that moderate to high risk appetite investors tend to prefer investing in equities and hybrid funds, the risk averse investors often get stuck with the traditional investment options like PPF, FD etc. Such investors can opt for debt funds in order to diversify across various fixed income securities while ensuring stable returns. However remember that debt funds too, are market linked investments, thereby implying that there are no guarantees with respect to returns, and the past performances, market scenario, expense ratio etc must be factored in by investors when investing in them.

What to factor in when investing in Debt Funds?

With 16 categories of debt funds available to choose from, selecting the most suitable debt fund category which can offer maximum risk-adjusted returns can be a tricky task. Choosing an incorrect category can lead to sub-optimal returns or even, at worse, capital erosion for the investor.

Hence, it becomes prudent to keep in mind these parameters and steps when choosing a debt fund:

1.Debt Fund Category

The first and foremost step investors should take towards selection of the right debt fund is to check out the 16 categories of debt funds and their features, risk, returns etc. Then, as per your risk appetite and investment horizon tied to your financial goals, opt for the optimal category. Once you are able to choose the suitable debt fund category, review the chosen fund¡¯s performance time to time in order to ensure that it¡¯s performing as expected, and if there is consistent under-performance over multiple quarters, then switch to some other debt fund scheme which is capable of providing the expected returns which assist in fulfilling your investment objective.

2.Debt Fund Expense Ratio

This ratio is the proportion of a fund¡¯s total assets utilised for meeting its total expenses. Expense ratio is considered a crucial factor while selecting amongst the numerous debt funds, as a slight difference in it can lead to a significant difference in your returns. Hence, it¡¯s better to opt for direct plans of debt funds, since these involve a much lower expense ratio vis-a-vis their regular counterparts. For example, Aditya Birla Sun Life Low Duration Fund¡¯s regular plan involves an expense ratio of 1.22% at present, whereas its direct plan¡¯s expense ratio is much lower at 0.39%. (As per valueresearch)

3.Portfolio constituents

In debt funds¡¯ factsheet displayed on their website, the list of credit ratings of their underlying portfolio constituents is mentioned. These credit ratings are an indicator of the creditworthiness of the issuers of those underlying securities. For example, instruments having a credit rating of AAA involve the lowest credit risk whereas those having a lower rating like A or C tend to be considered to have high default risk. Hence, checking the debt fund¡¯s factsheets when selecting the right fund can give you a fair bit of idea regarding the credit risk exposure of that debt fund and whether it is compatible with your risk appetite.

Debut mutual funds are different from equity funds. Learn about them by clicking here.

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