What you should know about debt funds

Forget equity markets and equity funds. Debt mutual funds are claiming the headlines with alarming regularity ever since IL&FS defaulted on its debt payments in September 2018. All this has brought to light certain truths about debt funds, which you should know before investing.

Debt funds confusing you?

Here’s truth number one. Debt funds are not exact replicas of fixed deposits. Debt funds invest in various debt-based instruments floated by companies, banks, NBFCs, and the government. The fund makes its return through accumulating the interest on these instruments or if the instrument’s price changes. Interest earned and price changes are reflected in the fund’s NAV, and NAV movement decides your return.

Since the debt fund invests in a wide range of instruments, which carry different interest rates, and whose prices can keep changing, there is no way a debt fund can guarantee a specific level of return. In this aspect, it is not a fixed deposit. Debt fund returns will fluctuate, though they never are as volatile as equity.

Here’s truth number two. Debt funds can give losses. A debt fund gives losses when there is prices of the bonds it holds falls, since the NAV reflects market value of the bonds.

Bond price falls can occur when debt markets fall due to changes in interest rates. A bond’s price can fall when the bond’s credit rating is revised downwards – this can be due to deteriorating financials of the issuing company or a default by the company on any of its dues. And finally, if the fund holds bonds and these bonds default on payment, the fund will have to write off the value resulting in a loss.

Defaults, however, are extreme cases. It is the contagion effect of the collapse of IL&FS – a systemically important financial behemoth – that is causing the current spate of default problems in NBFCs. Usually, what grips bond markets are changes in the direction interest rates will take. The fluctuations this causes in debt funds aren’t steep or extreme and even out over time. There are different types of debt funds, some of which react more sharply to rate changes and others that sit stable. For debt funds that react more, simply holding them for a longer period of time will counter fluctuations.

The gist so far is that debt funds aren’t fixed deposits, they cannot guarantee returns, and they can generate losses sometimes. So truth number three may be a surprise. Debt funds are great alternatives to fixed deposits. While debt funds aren’t fixed deposits, they perform the same role in your investments. The role is a low-risk, stable investment that can offset your riskier investments.

Recent events aside, debt funds are not high-risk and do not require you to take on substantially higher risk than your FD. You only need to keep two points in mind – one, know what your timeframe is and the reason for which you’re investing. This will tell you what type of debt fund to go for. The second is to be aware of what your investing in and how your fund makes its returns. This will help you set realistic expectations and prevent sleepless nights when your returns don’t behave the way you thought it would.

There are different types of debt funds, each of which react differently to interest rate changes, which have different risk levels, and different holding periods. As long as you’re with the right fund, your fund can deliver higher returns than most bank fixed deposits. We can get into a long-winded explanation why, but let’s put it in simple words.

When you invest in a FD, the bank borrows from you and uses the money to lend – at a higher rate. There is a margin for the bank. When you invest in debt funds, you are indirectly the lender as the fund is lending directly to companies. That is, there’s no mark-up. The only margin there is the expense ratio, which is lower than the bank’s mark up.

For most investors, especially the younger, tax-paying crowd, debt funds do hold immense potential. Tax treatment for debt funds is more favourable than fixed deposits when held for over three years.

So don’t throw out debt funds altogether – they have a place in your portfolio just as much as fixed deposits do.

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