Debt mutual funds invest in treasury bills, other money market assets, and fixed income instruments like corporate and government bonds. They help investors balance their portfolios for lower risks and offer them modest capital growth and a high degree of security.
Due to their consistency in returns, fixed-income funds—also referred to as money market funds—are less risky than equity-oriented ones. However, profits might not always be enough to keep up with rising costs. Educating yourself on the risks associated with debt mutual fund schemes before investing is essential.
The two primary risk concerns in debt funds should be understood before we explore how to choose the best debt fund:
Interest rate risk: Changes in interest rates hurt the price of fixed-income instruments: price decreases when interest rates rise and vice versa. The price sensitivity of various fixed-income products to changes in interest rates varies. Duration is another name for the price sensitivity to changes in interest rates. The sensitivity to fluctuations in interest rates increases with an instrument’s duration.
Credit risk: It is possible that the fixed income instrument issuers will not pay the interest and principal due. Rating agencies provide credit ratings to instruments after evaluating the credit risk of fixed-income securities in light of the issuer’s financial stability. The price of an instrument will decrease if its credit rating is reduced. The price will also increase if the credit rating is raised.
Liquidity risk: The risk of not being able to sell investments at fair market value and when the need arises is known as liquidity risk. Such conditions may develop due to weaker demand or a decline in order due to some issuer’s or groups’ unfavourable developments.
To maintain the best possible balance between risk and reward, liquidity risk is controlled by retaining higher-rated securities for improved liquidity, a liquid portfolio, and a diversified portfolio.
Why should you invest in debt funds?
Stable Returns
Due to their lower reliance on market emotion, debt funds are renowned for providing consistent returns. Debt funds allocate 65 per cent of their capital to less volatile debt securities than stocks, such as certificates of debentures, deposits, bond papers, etc. They may not produce as large returns as equities funds, but they do not fall as quickly because they are less subject to market fluctuations.
Low Risks
Debt funds are appropriate for cautious investors who want to maximise capital gains with the least risk. They are more resistant to market volatility when investing in fixed-income securities with set maturity dates and interest rates. Therefore, combining these funds with some equity funds in the portfolio balances the risk-return profile.
Emergency Funds
Debt funds are a good option for investing extra cash so that you may earn interest. Debt funds can be beneficial in achieving short-term objectives because they often offer higher interest than bank savings. Additionally, you can retain a cache of money in loan funds to build an emergency fund to handle sporadic monetary emergencies.
Flexibility
You have the choice to make a lump sum investment in debt funds if you have extra cash. Alternatively, you can make modest investments through Systematic Investment Plans or move units across funds using Systematic Transfer Plans.
Tax Efficiency
Debt funds give more tax benefits than bank deposits, even though equity funds might be more tax-efficient than debt funds. In addition to receiving reduced interest on your money when you deposit it in a fixed deposit, you also have to pay taxes annually. On the other hand, debt funds offer larger returns and are only taxed when the units are redeemed.
Conclusion
Debt mutual funds are appropriate for people who want to invest in securities that offer both capital appreciation and asset protection but have a low-risk tolerance. For these investors, debt funds may be utilised in place of conventional fixed-income assets like bank deposits. On the other hand, unlike traditional fixed securities like bank savings and post office investments, debt programmes do not guarantee returns. Both stock and debt programmes are subject to market risks.