Are debt funds as safe as they are made out to be?

  • To ensure debt funds work for you, know how to manage the associated risks
  • Short-term debt funds with a 100% AAA portfolio give better post-tax returns than options like bank deposits

When it comes to investments that are safer than others, debt mutual funds often figure on the list, sometimes as an alternative to fixed-income options such as bank deposits, bonds and small savings schemes. While investors are attracted by the tax advantage debt funds provide compared to other competing products, they tend to ignore the risks that come along. So unless there is a good fit between your particular need and the type of the debt fund selected, it can do more harm than good to your goals. That’s why it’s important to understand the risks in debt funds and to know how to manage them.

Advantage debt funds

Debt funds are preferred over other competing products, especially fixed deposits (FDs), for many reasons, including liquidity, tax efficiency and the possibility of better returns.

To start with, you can withdraw your money whenever you want. “Debt funds tend to provide greater liquidity, i.e., one can withdraw money from some of the debt funds like liquid funds without any penalty, whereas FDs generally have a penalty if they are withdrawn before maturity," said Lovaii Navlakhi, managing director and chief executive officer, International Money Matters Pvt. Ltd, a financial planning firm.

While some debt funds have exit loads, you can make them work to your advantage by aligning the investment tenure with the period for which the fund charges an exit load. For example, when investing in a corporate bond fund, which is meant for longer holding periods, make sure you don’t withdraw before a year as these funds penalize exit before that period. For shorter-term investments, liquid funds are suitable as they do not have an exit load.

Debt funds also offer greater flexibility on how much you can invest in one go—you can invest a lump sum or periodically. You can also choose between the dividend and growth options, based on your need for regular income and wealth creation, respectively.

The biggest of all is the tax advantage. If held for more than three years, debt funds tend to be more tax-efficient as long-term capital gains are taxed at 20% but after adjusting for inflation. “Some of the debt funds can give higher post-tax returns than FDs for slightly higher risk taken," said Navlakhi.

Risks along the way

For the advantages to play out in your favour, it is important for you to understand and evaluate the risks associated with debt funds. “Debt funds have either interest rate risk or credit risk or sometimes both," said Navlakhi.

Interest rate risk arises when the fund manager’s interest rate call or prediction goes wrong. There is an inverse relationship between bond prices and interest rates, which means when interest rates rise, bond prices or net asset values (NAVs) fall. “If the interest rate rises, the NAV of the debt fund, in most cases, will fall and vice versa. If the fund manager is expecting a rate cut then he will buy a debt instrument with higher maturity in his portfolio," said Tarun Birani, founder and chief executive officer, TBNG Capital Advisors Pvt. Ltd, a financial planning firm.

Then there is the risk of default by the issuers, known as credit risk. Funds are allowed to invest in debt papers rated investment grade by credit rating agencies. But within this band of investment grade, fund houses may invest in papers rated lower than the safest paper in the market. “There are 12.3 trillion of assets in debt funds and nearly 60% of these assets are in low duration products and those with relatively less credit risk like liquid and short duration funds. These categories seem to be relatively safer," said Sanjiv Singhal, founder and COO, Scripbox, a mutual fund investment platform.

“Some schemes may invest in low-rated papers to generate better returns," said Birani. However, if things go wrong for the issuer, the credit ratings can drop sharply, causing the debt paper and the fund to lose value.

How to manage risks

An efficient way to manage risks is to ensure that the type of debt funds you choose is aligned to your goal timeline.

It is also important to evaluate the portfolios of the schemes to determine your comfort with the extent of risk taken by the fund. “As per Sebi’s (Securities and Exchange Board of India) categorisation, debt funds are further subdivided into 16 subcategories. Depending on the investor’s risk profile and time horizon, one can choose the appropriate fund," said Ankur Maheshwari, CEO, Equirus Wealth Management Pvt. Ltd.

If you are looking to park funds for a short period, say, till the funds are used to meet your particular goal, your primary need would be to preserve the capital and not earn high returns. Ultra-short-duration and low-duration funds with low volatility in NAVs are preferred for this. Overnight funds and liquid funds are used to hold funds for extremely short periods where liquidity and capital preservation are important. While interest rate risk may not be a concern in these categories, the extent of credit risk has to be evaluated.

Short-duration funds are a good option to capture market returns if you want debt funds as a part of your overall asset allocation. You need to stay invested in these funds for two to three years for best results. Redeeming earlier may result in lower NAVs due to interest rate risk since these funds hold securities with longer tenors that could see a fall in value when interest rates rise. If you want higher returns and are willing to take some credit risk for that, go for corporate bonds. If you can increase the risk for even higher returns, consider credit risk funds.

“Unless you are a mature investor, stick with shorter duration funds," said Singhal. If you don’t like volatility, stick to low-risk debt funds that invest in higher-rated assets. “Short-term debt funds with a 100% AAA portfolio generate better post-tax returns vis-a-vis other options like bank deposits. It’s ideal to look for liquidity rather than volatility when an investor is closer to goals," said Navalakhi.

Scheme selection

Sebi’s re-categorization exercise has reduced the possibility of too much variation in the risk and return features of schemes, but funds can still show variation in performance based on how they build their portfolio within the regulatory limits.

When buying a fund, look at its historical returns but also evaluate the risks the fund takes to generate extra returns. For example, taking higher interest rate risk when interest rates are heading south may translate into higher returns, but the same portfolio will incur greater losses when rates are going up. Similarly, higher returns from investing in lower-rated papers works well, until there is a default, like in cases of downgrade of debt instruments from IL&FS Group, Essel Group and others.

Also, funds that have a large exposure to a single issuer will be more at risk if there is a default. “Size and track record of the funds is important. Prefer funds with more than 3,000 crore of assets," said Singhal. Like all investments, debt funds too come with risks. Make sure you align the risks and returns of the product with your own requirements.

Neil Borate contributed to the story