Mutual funds investors generally invest in debt funds to provide cushion to their equity-oriented portfolio. Debt funds are known to offer stable returns with minimum investment risk. When the equity markets are facing volatility, investments in debt assets are known to even out losses faced by equity mutual funds. It is less likely for all asset classes to work in tandem at the same time. This is why investors generally diversify their mutual fund portfolio with both equity and debt instruments. Also, since it is never a good idea to depend on one asset class for income generation, debt funds offer diversification as well as the much-needed liquidity to a mutual fund portfolio.
However, it is not necessary that every investor with choose debt funds only to provide a safety cushion. Some mutual fund portfolios are solely built using debt funds or they are debt heavy. That’s because not every individual carries same risk appetite. Also, there are some individuals who might have switched from conservative investment avenues to mutual funds and are investing in debt funds for steady income with minimal investment risk.
However, just because debt funds avoid investing in equity related instruments doesn’t make them entirely risk-free. There are few things investors should bear in mind while choosing a debt fund for their investment portfolio.
Interest rate risks
Having been touted as a safer investment option than equity funds, debt funds are known to carry interest rate risks. When the interest rates fall, it might hamper the performance of a debt scheme. Debt funds invest in bonds whose prices fluctuate just like that of stocks. Since bonds are known to offer fixed interest, a collapse in the interest rates with void all other bonds from having a better interest. This can affect a debt fund’s performance.
Credit rate risk
A credit risk is nothing but fear of the borrower failing to pay the interest rate on a date committed. This is also referred to as default risk. CRISIL is one of the rating agencies that gives borrowers ratings like AAA+, AAA-, etc. depending on financial health of issuer to determine their ability to repay promised interest. However, investors should understand that credit risk of a company will not remain stagnant. Depending on its performance, company’s credit risk appetite may increase or decrease. It is better to choose a debt fund that doesn’t invest in companies that have high credit risk.
What is your investment objective?
Currently there are 15 debt schemes each carrying a different investment objective, asset allocation strategy, risk profile etc. It is essential for investment objective of the scheme to align with of the investor. This is why investors should ask themselves why they want to invest in a debt funds. This might help them get a clear perspective on which fund to choose.
For example, if you want to build an emergency to tackle your life’s exigences, you can consider investing in a liquid fund or an overnight. The fixed income securities in which a liquid fund invests mature in just 91 days whereas overnight funds invest in overnight securities. These are ideal as investors need to liquidate their assets immediately in case of a financial emergency and investing in liquid or overnight funds can offer them the much needed liquidity.
Better than FD?
For investors who are switching from bank FDs because of the poor interest rates, such individuals can look at debt schemes like low duration fund, corporate bonds, Banking and PSU funds etc. who are known to offer slightly better returns without compromising your portfolio’s safety.
Debt funds must always be a part of every investor’s asset allocation strategy. However, the proportion in which asset allocation must take place may vary from investor to investor.