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How do debt funds complete your portfolio?

How do debt funds complete your portfolio?

Risk-averse investors or any investor who wishes to add a layer of stability to their portfolio would do well to explore debt funds in more detail.

Only way to grow one’s wealth is to invest in a variety of assets Only way to grow one’s wealth is to invest in a variety of assets

It is a well-established fact that the only way to grow one’s wealth is to invest in a variety of assets. These assets could include equity, debt, real estate, gold, and so on. Each of these assets also come with a degree of risk with some being riskier than others. Recently the financial markets saw an upheaval when the COVID-19 pandemic occurred and thousands of investors watched the value of their equity investments plummet as the markets took a severe hit. Some investors were able to stand their ground and wait out the turbulence. However, others realised that high-risk investments like stocks and equity mutual funds were probably not for them. How then should these investors continue investing to ensure that their portfolios have some amount of risk protection?

Exploring Debt Funds Further

Risk-averse investors or any investor who wishes to add a layer of stability to their portfolio would do well to explore debt funds in more detail. Debt funds are also known as fixed-income funds as they invest in fixed income instruments. These instruments could include Government-issued sovereign bonds, corporate bonds, treasury bills, and money market instruments. While equity mutual funds invest in stocks and are highly susceptible to market fluctuations, debt funds are relatively less affected by these changes.

The relative stability of debt funds comes from the way they are structured. Each debt scheme, depending on its investment strategy, invests in a basket of fixed income instruments. For example, a corporate bond fund scheme would invest at least 80% of its assets in bonds issued by corporates. A liquid fund scheme that has a maturity of no more than 91 days would invest in money market instruments with similar maturity periods. The various debt instruments typically have a fixed maturity, after which they are required to pay the investor back in full with any interest that the investment might have earned. While debt funds cannot guarantee returns, the issuer of the bond is obligated to pay back the principal amount to the investor once the bond matures. Therefore, debt funds are relatively less risky when it comes to losing capital.

The Benefits of Debt Funds

Debt funds, no doubt, are less risky than some other types of investment instruments. However, their benefits do not end there. These funds could prove to be a viable investment option for those investors who are looking to meet short term financial goals within the next 3-5 years. Debt mutual funds also show potential for relatively higher returns than other instruments like a banks savings account or even fixed deposits. Depending on the type of debt fund scheme, investors could even expect returns as high as 9% in some cases. It is, however, important to keep in mind that the rate of returns could fluctuate from time to time.

Debt funds are also highly liquid which makes them suitable for emergency and sink funds. As an investor, if you wish to park some idle cash to build a corpus for any type of emergency, you could consider investing in short duration funds or liquid funds. Not only is it easy to withdraw from these funds as and when required, but even in holding, the investment continues to have the potential to earn returns. Even modest returns of 6%-7% could add up over time and increase the invested amount.

Another benefit of fixed income debt funds is that they help to diversify an investment portfolio. An equity-heavy portfolio as we have seen earlier could be prone to high risk. However, by allocating a portion of the assets to debt, investors can create a more balanced portfolio that could be more resistant to risk. The asset allocation of this sort would no doubt depend on the investment goals and the risk appetite of the investor him/herself.

Risks Associated with Debt Funds

While we understand the benefits of debt funds, it is necessary to note that they are not without risk. Two of the more common risks associated with debt funds are credit risk and interest rate risk. Credit risk occurs when the organisation that issues the bond is unable to pay back the invested principal. This risk is higher in the case of debt schemes that invest in companies with low credit ratings. Credit risk can be lowered by investing in high-quality bonds of companies with high credit ratings.

Interest rate risk occurs due to changes in the interest rate of bonds. This happens when new bonds issued by an organisation have a higher interest rate than those already being held by investors. As bonds with higher interest rates have higher demand, the value of the bonds in holding drops. Consequently, this causes a drop in the NAV (net asset value) of those debt schemes that hold these bonds, leading to lower returns for the investors. Debt fund schemes with shorter maturity periods, like ultra-short funds, are less affected by interest rate risk than those with longer maturities. Floater funds, wherein the fund manager changes the maturity of the scheme based on market outlook, are another way in which investors could lower interest rate risk.

How are Debt Funds Taxed?

Investors in debt funds need to also be aware that returns or capital gains earned on debt funds are taxable. Capital gains may be short term (STCG) or long term (LTCG). Here’s how they are taxed:

STCG – When held for less than 3 years, is added to the investor’s income and taxed as per his or her tax slab.

LTCG – When held for 3 years or longer are taxed at 20% with indexation benefits.

Indexation takes into consideration the inflated buying price of the scheme units and therefore reduces the tax liability.

Capital gains tax is only applicable once the investment is redeemed and the amount is credited to the investor’s bank account. No taxes apply while the investment is still in holding.

Debt funds are a good investment option for conservative investors and those investors who would like to create a more robust portfolio. Not only are these funds less affected by market fluctuations, but they also have the potential to generate moderate returns and can be highly liquid, making them a good option for emergency funds as well as a way to meet short-term financial goals.