So many people park their money in traditional debt instruments such as the Public Provident Fund (PPF), Employee Provident Fund (EPF), and Sukanya Samriddhi Yojana (SSY) to fund their debt needs. Ask any investor about his or her understanding of investing in debt instruments, and you will find most of them share these government-backed schemes as their primary options.
Those saving for retirement allocate their earnings to these government-sponsored schemes as a part of their debt portfolio. Of course, there are other options like fixed deposits and recurring deposits that many people love to park their money in to ensure enough funds for emergencies.
While there is nothing wrong with these traditional schemes, what if we need our money five or seven years down the line? Not all financial goals may be in sync with what traditional investments promise, especially, in terms of tenure. What if we do not want to risk our money in equities but are also yearning for good returns with time?
And, then there is the burden of tax too, which eats up the returns that we earn from these financial instruments. As opposed to fixed and recurring deposits that may figure in the 20-30 per cent tax bracket depending on how much you had earned as interest income, debt funds are taxed at a flat 20 per cent rate with indexation, thus, lowering the effective tax rate as per inflation.
Also, the Income Tax guidelines stipulate the deduction of taxes from income on fixed-income instruments like fixed deposits and recurring deposits every year. Compare this with the taxation of debt funds that are applicable only on fund redemption. Time is the biggest factor in determining mutual fund returns. This applies to debt mutual fund instruments too as their returns depend on how long you had stayed invested. This adds to their benefits as debt funds yield considerable returns after five to seven years, which will bring you a step closer to your short-term financial goals.
You may ask if returns from debt funds are fixed. The answer is ‘no’ as the uncertainty of returns adds to people’s concerns. Ironically, the same people do not question the unpredictability of equity mutual funds even after realizing how their growth is connected to the stock markets. Though there is a certain level of risk associated with debt fund returns, investors can take care to park their earnings in reasonably ‘safe’ debt funds considering simple measures.
Parking a small portion of your earnings to EPF and PPF is understood, but what if you have a big corpus and are looking to plan your retirement? Irrespective of how much you may be earning now, the continued decreasing value of money makes it imperative to invest in instruments that would fetch higher returns beating the impact of inflation.
Once you have earned enough through returns and decided on your allocation of savings to investments, it is time to rebalance your portfolio. If you have short-term goals like a marriage or expenditure on your honeymoon or planning some extra coaching for your children, choosing debt funds over EPF and PPF would serve you best. This is because the entire amount can be redeemed whenever you want within a short term, thus, allowing you enough money and the freedom to use your money whenever you want.
Also, you cannot shift large chunks of your money to EPF or PPF owing to regulatory restrictions concerning investment limits.
How to invest in debt funds?
You need not jump to debt funds altogether. First, invest in equities and then after some years, take out a chunk of your money and shift it to debt instruments, thus, allowing scope for both high returns and minimised risk. Personal finance experts refer to this as systematic de-risking, which means shifting a portion of the equity fund returns to debt to ensure that you do not lose the earnings to a sudden market crash.
This slow and gradual shift from equities to debt must be considered when you are nearing retirement or planning for your child’s higher education. You surely would not want to mess up with the corpus created for which you had planned and worked so hard. So, slowly moving to debt becomes the best available option. Withdraw the corpus in full or in parts only at the time of retirement.
This means that you put only that much amount in savings accounts, and fixed and recurring deposits that you believe might be needed to tackle emergencies. The thumb rule clearly states that one must hold 6-12 months’ worth of expenses in safe instruments like FDs for emergencies.
Managing portfolio with debt funds
Never underestimate the benefit of putting your money in debt funds. When deciding on your investments, do not look at returns alone. Know how much risk you can assimilate. Apart, liquidity as an essential element of investments cannot be discounted. The ability to freely redeem or reinvest at will is essential to portfolio management.
Prathiba Girish, Founder, Finwise Personal Finance Solutions says, "Debt funds are usually held for short-term events or as debt part of long-term asset allocation. Either way, what is sought here is the safety of capital along with availability when needed, i.e., liquidity. We believe debt is not an asset to take unnecessary credit risk, hence, the quality of papers funds hold in terms of both safety and liquidity is very important."
The liquidity factor is limited in investments like EPF, PPF, SSY and National Pension Scheme (NPS). Rahul Agarwal, Proprietor, Advent Financial says, “Debt mutual funds offer investors similar returns particularly if one were to compare the funds with underlying maturity similar to traditional post office investments. An added bonus here is liquidity if the need were to ever arise."
“However, one must be mindful of potential liquidity risks, particularly under adverse market conditions where the fund could face redemption pressure and may not be able to generate liquidity by selling its security holdings. Ideally, investors should look at choosing funds whose underlying maturity matches their intended holding period,” he added.
While debt funds have their benefits, do not go overboard with them. Remember that every kind of financial instrument has its pros and cons. Exercise prudence while making your investments.