Investing In Debt Funds: Best Practices

Article Summary

Debt funds can fulfil important needs like serving as emergency funds, managing market-linked investment risk, preserving capital, and generating regular income.
To choose the right debt fund, understand the various risks—interest rate risk, credit risk, reinvestment risk, and inflation risk.
Identify the right debt fund category by first determining the goals and tenure and then an acceptable risk level.
Within a debt fund category, compare performance over 6 months, 1, 2, and 3 years with scheme benchmarks and peers.

Most of the investor conversations on investments often tend to move around subjects like performance over different periods of time and risk. However, you also need investments for needs such as meeting emergency needs where easy access to money is required, securing long-term gains from higher-risk investments, and generating income. This is where debt fund investment comes into the picture. They typically help you meet shorter-term needs expected to arise in the next 1-4 years. So, what are debt funds?

What Are Debt Funds & How Do They Work?

In order to identify and invest in the right debt funds you need to have a basic understanding of how debt funds work. Debt fund schemes invest in various debt investments such as government securities, corporate bonds, and certificates of deposits, for various tenures and risks. They are lower risk investments compared to equity and equity-oriented mutual funds and may be suitable for needs arising in 1-4 years. Within debt funds, investors can choose according to their risk appetite and needs. Thus, the more imminent the need, the lower the risk of the fund you may choose.

How Investing in Debt Funds Helps

Debt fund investments help investors meet a range of needs that are equally important as the healthy growth of money for major needs like retirement. Here are some of them.

Emergency needs

During emergencies, instead of tapping into long term investments, liquid funds, overnight funds, and short term debt funds may provide easy access to money.

Manage market-linked investment risk

During rapid run-ups in equity markets and appreciation of investments, investors effectively end up taking more risk than they are comfortable with. By moving a part of their equity investments, or with fresh debt fund investments, investors can reduce the risk levels with portfolio rebalancing.

Preserving capital

Debt funds can serve as a lower risk parking slot for preserving capital when approaching financial goals like retirement or children’s higher education. Investments in higher risk, equity and equity oriented funds can be shifted to shorter term debt funds.

Regular inflow

Since debt funds experience lower fluctuations and for shooter periods of time, they are suitable for generating regular inflow through Systematic Withdrawal Plan (SWP), involving the periodic sale of units to meet income needs such as in retirement.

Periodic lump sum income

Regular investments in closed ended schemes like Fixed Maturity Plans (FMP) and target dated debt funds, can provide periodic lump sums for needs such as periodic home improvement needs.

How Understanding Debt Fund Risk Holds the Key

Like other investments, debt funds also have associated risks. To be able to choose the right debt fund, an investor needs to be aware of the following risks.

Interest rate risk

While it is important to manage the impact of interest movements, this risk is more in longer term debt funds. Thus, the more proximate the need for money, the shorter the term of the debt fund you need.

Credit risk

While debt funds investing in debt securities with higher credit or repayment risk, may have the potential for higher rewards, investors with shorter-term goals need to deliberate whether taking the risk is justifiable.

Reinvestment risk

The risk of finding suitable reinvestment options is applicable mostly for investments in closed-ended schemes.

Inflation risk

Since debt funds take up lower risk, consequently, their potential returns may be lower. Over long periods their returns run the danger of being eclipsed by inflation. This is unlikely to be an issue for shorter term needs arising in 1-2 years.

How to Choose the Right Debt Fund

Having grasped the risks associated with any debt fund investment, an investor needs to take the following essential steps to choose the right debt fund.

Identify your need and investment tenure

Any debt fund investing needs to be guided by the short term or other financial goal that it would be earmarked to. Depending on the time to the financial goal, the investment tenure would be determined.

Determine your risk level

The investment tenure, determined by the time when you need the money, in turn, will determine the risks you can take. For instance, for near-immediate or imminent needs, your credit risk needs to be the minimum possible and you need easy access to your money.

To reflect the risk, mutual funds must mandatorily visually depict the risk levels with the use of Risk-O-Meter, present in all scheme documents. Investors can take the help of this visual depiction of risk as well as go through discussions on risk in scheme documents.

Identify the debt fund category

Depending on the time to financial goals and the risk, you can identify the right debt fund categories. There are 15 debt fund categories according to categorisation by mutual fund regulator SEBI. They are overnight fund, liquid fund, money market fund, ultra short duration fund, short duration fund, medium duration fund, medium to long duration fund, long duration fund, dynamic bond fund, corporate bond fund, credit risk fund, banking and PSU fund, gilt fund, gilt fund with constant duration and floater fund.

Examine the performance track record

Having identified the right debt fund category, you may compare the performance track record of different funds within the category with respect to their benchmarks and peer funds. This comparison needs to be done over different time periods such as 6 months, 1, 2 and 3 years. This exercise will help you zero down on the right debt fund for one time investment or a regular investment through Systematic Investment Plan (SIP).

It is clear that debt funds play multiple and important roles in your finances. By following the best practices in debt fund investing, you can ensure that they help you meet various financial goals.

FAQs

What is the difference between fixed deposits (FD) and debt funds?

FDs typically involve investing a lump sum, staying invested for the tenure for which you receive interest, with penalties for premature exits. Debt funds allow small and regular investments and provide easy access to money. Expert fund managers attempt to deliver higher returns through capital gains and coupon payments, typically taking higher risks.

What is the right risk level for a debt fund?

The more imminent the need for money, the lower the risk of the debt fund needed since easy access and security of money are the primary requirements.

What kind of financial goals are suitable for debt funds?

Typically, debt funds work well for needs arising in 1-4 years. Higher risk, longer term debt funds typically work well for money needed in 3-4 years. Thereafter, inflation risk rises substantially.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.