Things to remember when investing in debt funds

In our obsession for investing in equity funds many investors often forget that there is something called debt funds which also offer them a very interesting alternative. Investing is not just about returns but also managing risk and about managing liquidity. Debt fund play some very important roles. Firstly, they give stability to the portfolio. Secondly, they protect value better than equity in the short to medium term. If you have a 2-3 years perspective, you are better being in debt than in equity. So how do you go about investing in debt fund?

Ten things to remember when investing in debt funds:

1)What should be your total exposure to debt? That largely depends on your financial plan so that is where you got to start. When you have goals that require stability and certainty of flows, then debt funds make a better fit. Also, as your risk appetite reduces, your proportion of debt funds in the overall portfolio should be on an uptrend.

2)Your portfolio needs growth and wealth creation but that alone is not enough. You also require an element of stability that only debt can provide. When you are in debt funds, your longer period returns may be lower than equities, but you get the much needed stability and predict→ability to your portfolio.

3)There is a wide choice available even within debt funds. Debt funds may be a single word but it is a wide array. You have variety in terms of duration ranging from very short term liquid fu→nds to long term gilt funds. You also have choice in terms of credit risk ranging from corporate funds to credit opportunities funds. You can select as per your need.

4)The challenge is you cannot get regular incomes through equities. Equities pay dividends and also give capital gains, but there is no assurance or guarantee of the same. You can structure a debt fund as a growth plan or as a dividend plan but either ways you can be assured of regular income. Different methods of taking returns out a debt mutual fund have different tax implications. What matters is that if you require regular income from your investment, you can structure that via exposure to debt mutual funds.

5) Your risk appetite varies and normally depletes with advancing age and shrinking income. The idea is to use debt funds to keep reducing and tweaking the average risk of your portfolio. Remember, debt is not risk free. It is just that it is more stable and predictable compared to equities in the medium term.

6) This lower volatility of debt funds makes them ideal instruments to reduce overall risk of your portfolio. When you create a portfolio of assets, you have a target return and a target risk. That total target risk can be achieved through inclusion of debt funds into your overall portfolio.

7) Debt funds and liquid funds are very useful when you want to plan for your milestones along the path to your goals. Let us say you want to reach a corpus Rs 10 lakh in 3 years to pay margin for your home loan. Equities may be the wrong choice and you can look to have a greater proportion allocated to debt funds for this specific need. As you approach the milestone, you can keep increasing the exposure to debt funds and later to liquid funds so that around your milestone your risk of loss on liquidation is almost minimal. Debt funds balance risk and returns around your milestones.

8) Debt funds are extremely dynamic and flexible. Most of us tend to club all debt funds as fixed return products. That is not the case. For example, if you find that the risk of shifting from AAA rated debt to AA rated is not too high practically, then you can do quality-fishing by shifting to bonds with lower rating profile but higher return potential. You can also shift from long duration to short duration based on your view on rates.

9) Debt funds also play on interest and inflation. When you invest in a bank FD, what happens if the rates go down in the market? Your subsequent reinvestments will happen at lower rates. In case of debt funds, lower rates will reduce bond yields and increase the bond prices. This will result in capital gains through NAV appreciation, especially in case of long duration funds.

10) There is also a tax angle to it. Debt funds are more tax efficient when compared to other debt products. Interest earned on bank FDs and corporate FDs are fully taxable in your hands at the peak rate applicable to you. This could be 20% or 30% as the case may be.

You can structure your debt fund as a growth plan and hold it for more than 3 years so that it is classified as LTCG. In this case, the entire return earned over 3 years is taxed at just 20% with indexation benefits.

Debt funds are surely a value-add to your portfolio. There are some basics you need to grasp before investing in these debt funds.

(The writer is Assistant Director and Chief Sales Officer at Angel Broking)