We always talk about asset allocation which makes debt oriented investments a natural choice for all types of investors.
Fixed deposits, floating rate bonds and post office schemes like NSC & PPF form a part of the debt universe where the returns are pre-set and guaranteed.
Debt oriented mutual funds are a parallel investment option where the returns though not guaranteed fall within a range and safer avenues to invest in vis-à-vis their equity counterparts.
Is there a risk in investing in these debt oriented mutual funds or are they 100% safe?
Broadly speaking, there are two kinds of risks associated with investments in debt oriented mutual funds which are:-
- Interest Rate Risk - The general interest rate movement in the economy affects the performance of debt funds. To explain this simplistically, if the interest rates head southwards or move down, the yields of the bonds / papers in the existing funds go up and so does the mutual fund NAV too. For ex: If there is a debt fund that has invested in a bond with 10% coupon and if the interest rate falls to 9%, the demand for the older fund that the fund is holding at higher coupon rate will go up that will increase the bond price resulting in the appreciation of the fund NAV. The opposite would happen if the interest rate goes up as the bond price and hence the fund NAV would fall down. This price movement of NAVs because of price movement of bonds due to interest rate changes is termed as Interest rate risk.
- Credit Risk - This is another important risk of investing in debt funds owing to the credit quality of the papers (commercial papers, certificates of deposits, etc) the mutual fund invests in. There are credit rating agencies like CRISIL, ICRA that rate these papers issued by banks & companies and these ratings must be thoroughly analysed before making any investment. AAA rating is the highest rating given to any paper. This rating is a parameter to assess the default risk with these debt papers issued and the higher the rating, the safer the issue and lower the risk.
Having understood these risks on a broader level, let us now study about some of different kinds of debt oriented mutual funds starting with liquid or overnight / money market funds that are perfect substitutes of holding money in savings bank a/c. These are the safest options in the debt mutual fund space with negligible risk. The overnight funds are good for up to a week-long investment horizon while liquid funds can be considered for horizon over a week or a fortnight.
Next in line come the Ultra-low duration funds, Low duration funds, gilt funds, short term debt funds, corporate bond funds and banking & PSU funds. These funds generally carry lower interest rate risk as they invest in high rated papers that form a predominant part of their portfolio.
The gilt funds as the name suggests invest purely in securities issued by the government and so are highly safe avenues to invest in. Having said that, they are highly volatile due to the interest rate movements which impact the yields of these funds greatly.
The following chart clearly depicts the preferred investment horizon of these debt oriented mutual funds-
These avenues yield return comparable to bank fixed deposits and even beat the FD returns by a decent margin. Also, when you invest for 3 years or more, there is a tax benefit inbuilt in these funds where the capital gains are taxed at 10% without indexation and 20% with indexation.
If you want to beat the FD returns sizably, that can happen as you invest in riskier dynamic bond funds or credit risk funds. These funds are actively managed debt oriented mutual funds which invest in multitude of options / papers carrying different kinds of risks. For example, credit risk funds as the name suggests invest in papers with lower credit ratings too and that is their investment philosophy to generate the alpha.
When choosing the right debt fund to invest in, it is imperative that you list out the following:-
- Your investment horizon
- Expected returns from debt part of your portfolio
- Associated risk with chosen options
Based on these three parameters and of what has been explained above about the different kinds of debt oriented mutual funds, you are least likely to falter with your investment decision.