The current equity market looks volatile and major indices are already down by almost 10% from the recent high. For instance, currently Nifty 50 is trading below 17,000-mark compared to its recent high of 18,600. In such a scenario, it is a good idea to park a certain part of your investments towards fixed income funds or debt mutual funds. Knowing and understanding such funds and associated risks could help investors to leverage the benefits of this asset class and also help choose the right fund for their portfolio.
What is a debt mutual fund?A debt mutual fund is also popularly known as a fixed-income fund that invests in fixed-income securities such as government securities, treasury bills, commercial papers, debentures, highly rated corporate bonds, and other money-market instruments. All these instruments have a pre-determined maturity date and fixed interest rate that the buyer can earn on maturity. Thus they are called fixed-income securities. As the returns are generally not affected by fluctuations in the market, debt mutual funds are considered to be low-risk investment options.
Mechanics of debt mutual fundEvery debt instrument has a credit rating which indicates the possibility of default by the debt issuer in payment of interest and principal. Generally, debt mutual fund managers use these ratings and other factors to select good quality debt instruments. But depending on the scenario, sometimes the fund managers may choose low-quality debt instruments which offer an opportunity to earn higher returns and the fund manager takes a calculated risk.
Types of debt mutual fundsBased on the maturity period, debt funds can be classified into different types. Liquid funds are those funds which invest in money market instruments only which have a maturity of maximum 91 days. Dynamic bond funds invest in debt instruments of varying maturities based on the prevailing interest rate regime. Contrary to the above, corporate bond funds invest a minimum of 80% of its total assets in corporate bonds who have the highest credit ratings. These funds are good for investors with lower risk tolerance and seeking to invest in high-quality corporate bonds. Similarly, we have theme oriented funds such as banking and PSU fund, gilt fund, and other type of funds like credit risk fund, floater fund, etc.
Consider the followingBefore investing in a debt fund, assess your investment objective. For instance, you may wish to park your money until the volatility in the equity market settles down or may want to create an emergency fund, etc. So, once you identify your investment objective, the process of selecting the right fund becomes easier.
Another factor is the investment holding period as every investment goal has a specific time limit. If you have a short-term investment goal of around three months to one year, liquid funds are preferable. If the tenure is between one to three years, you can go for short-term debt funds. But if you have an intermediate time horizon of three to five years, dynamic bond funds are ideal.
To conclude, debt mutual funds are not free from risk as they are exposed to interest rate risk, which is the effect of changing interest rates on the value of the scheme’s securities. However, debt mutual funds generally provide predictable returns, high liquidity and thus making them one of the preferred investment instruments for investors who have a low risk appetite.
The write is a professor of finance & accounting, IIM Tiruchirappalli