Due to the lack of basic investment knowledge most investors do the rookie mistake of investing all their assets in one type of Investment Avenue. If you consult any financial advisor, they will suggest that the key to a successful investment portfolio is diversification. To seek diversification, an individual has to expose their portfolio to various asset classes like equity, gold, debt, etc. While people often jump to equity for obvious reasons, they fail to realize that adding debt to their portfolios is equally important.
Debt mutual funds have evolved over the years and are one of the prominent investment tools for investors to grow their money. Anyone who is starting their investment journey should include debt funds in their portfolio. If one has to consider debt funds, one should also have a clear understanding of how to choose the right debt fund. For that they first need to understand what debt funds are and how they work.
What is a debt fund? How does it work?
A debt fund is a mutual fund scheme that invests the majority of its investible corpus in debt and debt related instruments. Depending on the fund’s investment objective, a debt fund may invest in fixed income securities like corporate and government bonds, commercial papers, treasury bills, certificate of deposits, reverse repo, etc. Debt funds invest in low risk securities and hence may also generate low returns as opposed to equity mutual funds. But that also makes debt mutual fund investments much safer than equity investments that are highly volatile and equally unpredictable. Different debt funds have different maturity periods and their ability to generate returns varies based on their portfolio maturity.
Although equity funds offer a high risk rewards ratio, not all investors are willing to take that kind of risk with their capital. Such risk averse investors find debt funds as an excellent alternative for wealth creation. Debt funds offer better returns and flexibility than conservative investment avenues like bank FDs, PPF, post office, etc.
Here are a few things to keep in mind before investing in a debt mutual fund –
Interest rate movements
Since debt mutual funds invest in fixed income securities, they are inversely related to any fluctuations in the interest rate. Whenever the interest rates are on the rise, debt funds tend to generate lower returns. Similarly, when the interest rates fall, debt funds are able to generate better returns. Debt funds that have a long maturity period are more prone to interest rate risk. Having said that, if you want your investments in debt funds to generate decent returns to help you build a commendable corpus you will need to remain invested for a longer duration.
Credit quality of the underlying debt instruments
Debt securities are given credit ratings based on their ability to repay the borrowed sum within the stipulated period. Securities with high credit ratings like AAA, AAA+ are less likely to find their way in the defaulter’s list. However, some debt securities with AA, AA- or lower credit ratings have a high credit rate risk. Investors must make sure that they invest in a debt fund that suits their risk appetite. High credit rated securities have low risk low returns ratio whereas low credit rated securities have a high risk rewards ratio.
Debt funds held for any duration more than 36 months are qualified for LTCG tax of 20% after indexation benefit, whereas debt funds held for a duration less than 3 years are qualified for STCG tax. So investors will get tax benefits depending on which debt scheme they choose.