In May 2022, mutual funds that invest in debt securities had a net outflow of ₹32,722 crore. This follows a ₹54,656 crore inflow in April, according to figures from the Association of Mutual Funds in India (AMFI). This outflow comes after the increase in the policy rate by the Reserve Bank of India to tackle the rising inflation in the country.
However, it is essential to understand that institutional investors dominate liquid & money market schemes and debt-oriented schemes. Institutional investors constituted 90% and 62% of liquid, money market and debt-oriented schemes, respectively, in May 2022, as per AMFI data.
Have you ever invested in debt mutual funds? If not, then as an individual investor, there are a few things that you need to know before investing in debt mutual funds. Debt mutual funds are complex, and investors often make mistakes while buying them.
Here are some of the pointers that investors should know before investing in debt funds:
Wealth creation is not the main objective of debt funds
Many investors consider mutual funds as an investment option that delivers similar returns. But there are different types of mutual funds, and each mutual fund has its own set of objectives. While wealth creation is an important objective of equity mutual funds, it is not the same for debt funds.
Debt funds should not be considered wealth-generating investments. If you invest in them, it won’t be right to expect returns like equity funds from them.
The main goal of most debt funds is capital protection and providing a regular source of income to its investors. So, it tries to keep volatility at bay and protect the portfolio from market swings.
The debt fund returns are not safe
It is seen that most individuals start investing in debt funds believing that debt funds are entirely risk-free. It is not true as there are many risks associated with debt funds. Market risk, credit risk, and default risk are some of the main risks associated with debt funds.
As debt funds invest in different debt securities such as bonds, changes in the underlying bond price held by the fund will also impact the fund's unit price or Net Asset Value(NAV). The bond prices may vary due to changes in interest rates. Longer-term maturity papers are more sensitive to changes in the interest rate than securities with lower and medium maturity terms. So funds that invest in longer-term papers face greater market risk.
Corporate debt securities are also exposed to default risk and credit risk. Default risk is the risk of the issuer failing to repay the interest or principal on time. Credit agencies can also downgrade these debt papers, resulting in a fall in the debt fund's NAV. When this happens, bond prices of stable companies may also be affected.
Debt fund returns are not fixed
Debt funds aren't the same as bank fixed deposits that give a fixed rate of return. So, debt fund returns aren't guaranteed. We have already seen that the returns of the debt funds also depend on the vagaries of the market and changing nature of the underlying debt instruments. So, you can’t expect a fixed return like an FD from debt funds if you invest in these funds.
Debt funds are alternatives to existing fixed income instruments
Most individuals have exposure to PPF, corporate or bank FDs and post office schemes. These instruments, like debt funds, fall under the debt asset category.
So, if you want to diversify your portfolio and have already invested in the instruments mentioned above, investing in debt funds won’t help in asset diversification. In this case, you can look at reducing your exposure to existing debt instruments and investing in debt funds.
Debt funds are tax-efficient than bank deposits
Unlike bank deposits, debt funds don’t deduct tax at source (TDS). If you opt for the growth option of the debt fund, you only need to pay tax on the capital gains when you redeem your money. Moreover, if you redeem your investments after three years, you must pay taxes on the capital gains after indexation. Indexation allows you to adjust the price of your assets to account for current inflation. As a result, it is more tax-efficient than bank deposits and other traditional saving options.
Conclusion
Before you decide to invest in debt funds, take a moment to consider the reasons why you're investing in debt funds in the first place. Are you aware of the risks and how debt funds can help your money grow? These are all critical questions to ask before investing in a debt fund.
Padmaja Choudhury is a freelance financial content writer. With around six years of total experience, mutual funds and personal finance are her focus areas.
Follow the entire series on Financial planning here.
