Whenever we hear the word mutual fund, the first thing to cross our mind is the stock market, equity, risk, etc. But have you ever thought of debt mutual funds?
Debt mutual funds invest in corporate bonds, government securities, treasury bills, commercial paper and other money market instruments. Investing in debt means giving a loan to the issuer (the company) to run their business in exchange for periodic interest payment. Depending on the credit rating and tenure, debt instruments are chosen to suit the criteria of the fund. Credit rating shows the ability of the company to pay timely interest and the repayment of principal on maturity. The higher the rating, the safer the bond.
How to choose the right debt fund?
When it comes to choosing the right debt fund, there are several things that need to be considered. Apart from your own investment horizon (short-term, long-term or medium-term), you need to understand the risks involved while choosing the right debt fund for you. Typically, there are two types of risks that you need to keep in mind:
- Interest-rate risks – These risks stem from changes occurring in the interest rates in the economy. Usually, interest rates don’t fluctuate much in the short-term but over the long-term, they tend to fluctuate more. The impact of change in interest rates on short term funds is lower as compared to longer-term funds.
- Credit quality risks – These risks stem from the credit rating of the instruments/papers the debt fund invests in. A higher-quality credit paper indicates a low chance of payment defaults while a lower credit quality paper indicates a higher risk of a payment default. However, the trade-off in case of lower-rated papers is that they offer you higher yields to compensate for the higher risk.
Along with the risk appetite, you need to be mindful of the time horizon you want to invest for. Short-term debt funds are great if you are looking for liquidity more than returns, where the primary purpose is to park money for a short period to be used in the near future. You could consider short-term debt funds where the maturity or the time of repayment can range from being one-day (overnight -fund category) or up to 3 years (any short-term debt fund category). Short-term debt funds typically generate returns higher than say, a savings bank account.
For medium-term to slightly long-term financial goals, you could consider funds such as the medium duration fund (3-4 years), medium to long-duration fund (4-7 years), corporate bond fund and credit risk fund categories.
Long-term debt funds that have a much longer maturity, have higher exposure to interest rate-risk as compared to short-term funds. Additionally, you also need to take into account the credit risk associated with the different debt funds based on your risk appetite.
Further, debt funds qualify for long-term capital gains tax if held for a period of over 36 months and are taxed at 20% plus indexation benefit. For holding period of 36 months or less, short-term capital gains tax is applicable based on an individual’s income tax slab.
Debt funds are comparatively safer as an asset class and must, therefore, form a part of your core portfolio to balance out the overall risk. Smart investment is not just about earning higher returns or simply growing your money by investing in one type of asset class, it is also about diversifying across asset classes to get better risk-adjusted returns. Each asset class, be it equity or debt or gold or real estate, comes with its own risk. So, to shield yourself from such risks it is important that your investments are spread out among various asset classes. This will provide higher protection to your capital and increase the potential to earn better returns.
