Why Debt funds are the Golden Geese of your Investments?

In a world with a plethora of investment options, picking the right financial instrument is like choosing the right dance partner - someone who matches your rhythm. Debt funds often stand out as an efficient and rational choice for those who want to tango without stepping on toes. This article gives the reader a comprehensive understanding of the bigger potential of the usually underestimated debt funds in your investment portfolio, breaking down the complexities of risk, tenure, returns and various other parameters with respect to fixed deposits, debt funds and equity funds.

Your Investments as a platter

Imagine you’re at a buffet. Fixed deposits are your white rice—safe, predictable, and somewhat boring. Equity funds are spicy biryani—exciting but occasionally overwhelming for your taste buds. Debt funds? They’re like pulao: balanced, flavorful, and unlikely to cause indigestion.

Quickly defining the trio before a deep dive:

1. Fixed Deposits (FDs): A guaranteed investment vehicle offered by banks, where you park your money for a fixed tenure at a predetermined rate of return. 

2. Debt Funds: Think of these as loans that you are giving out to big corporations or governments who promise to return your investment with a fixed interest rate. They’re designed to provide stability and moderate returns without the volatility of equities. The risk is significantly lower than equities because these instruments prioritize repaying their investors. These include corporate bonds, government bonds, duration-based funds (low/medium/long term, etc) that can be invested in to suit your financial goal.

3. Equity Funds: These invest in stocks of companies, which have a higher risk element as compared to debt funds or fixed deposits. This is because returns from equity funds are determined by the growth of the company invested in. Therefore, investing in the right company is imperative, to capitalize on its growth.

Risk

In finance lingo, risk is the possibility that your investment could lose value. Each of the three discussed above come with their varying rate of risk. 

There are three types of risk we should understand before delving deeper into individual instrument associated risk. 

• Credit risk refers to the possibility that a borrower or issuer of a debt instrument may default on their repayment obligations, leading to financial loss for investors. 

• Liquidity risk occurs when an investor cannot quickly sell an asset at its market value due to a lack of buyers, potentially causing delays or lower returns on investments. 

• Interest rate risk is the potential for a decline in the value of an investment due to changes in interest rates, as rising rates typically lower the price of existing bonds or fixed-income securities. 

Together, these risks impact the stability and returns of investments.

Fixed deposits are relatively the most safe but they offer you low returns compared to the other two. FDs generally have low credit risk especially when deposited with established, government-backed institutions and interest rate risk because your investment is locked in at the time of investment. However, you will lose out on gains if the interest rates rise after locking in of investment.

 Equity funds involve high levels of risk regardless of their good returns and are largely unpredictable because it is essentially a bet that the company you now partly own will reap profits in the future, with your money at stake. This bet can be made an informed decision with ample research. They have low liquidity risks except in extremely unfavourable market conditions and low credit risk except when the company is undergoing financial challenges and facing difficulties to function. Interest rate does not directly affect the equity fund. However, if interest rates increase, it leads to a reduction in corporate profits, causing stock prices to fall which can thus affect the performance of the fund.

Debt funds involve slight risk (credit rate and interest rate risk), since you have essentially lent money at a fixed rate of return, and it’s invested in instruments that promise a fixed return, like corporate bonds or government securities - these are also called fixed-income securities. It’s the wall street’s version of "first-come, first-served."

Debt funds carry credit risk. Higher the credit rating for the fund, lower the risk of default. For investors who prioritize safety, it's important to be cautious with funds that hold more than 65% of their investments in bonds rated below AA (such as A+, A, or lower). These lower-rated bonds carry a higher risk of default, meaning there’s a greater chance that the issuer might not be able to pay back the money. Instead, consider focusing on funds that primarily invest in government securities with a top AAA rating, which are considered extremely safe. These high-quality investments are typically found in Liquid Funds, Gilt Funds, and Money Market Funds, which offer more stability and security for your money. They are highly sensitive to interest rate changes as well and thus carry high interest rate risk. When interest rates rise, the value of existing bonds in the fund’s portfolio tends to fall, which can lead to a decline in the net asset value (NAV) of the fund. NAV tells you how much each unit of the fund is worth at any given time. Conversely, when interest rates fall, bond prices tend to rise, which could lead to higher returns for the debt fund. The longer the maturity of the bonds in the fund, the higher the exposure to interest rate risk. They carry moderate liquidity risk for, if the market for a particular debt instrument is thin or if the market is undergoing disruptions, it might become difficult to sell the bonds at the desired price, leading to potential delays or lower returns on redemption.

Returns

Returns are the profits you earn on your initial investment over time. Fixed deposits offer returns that are consistent but low-yielding, often failing to beat inflation. Equities on the other hand offer high returns but are perpetually subjected to the risk of losing your investment. Debt funds are the perfect balance between uncertainty and good returns. 

Akin the Goldilocks Dilemma, about an entitled guest, quashing boundaries and furniture to find the bear soup that felt “just right”, everyone wants returns that are “just right” too. Debt funds find the returns that are of the perfect balance between risk and reward and often outperform FDs without the uncertainty of equities.

Tenure

Investing is all about timelines. And timelines are defined by your goals- financial or personal. Fixed deposits lock your money for a set period. Equity funds are ideal for long-term investors but can be risky if the goal is underpinned by a shorter time horizon.

Debt funds are the flexible partner. Whether your goal is a year away or five years ahead, there’s a debt fund for that. Finance folks call this duration management, meaning you can pick an investment horizon for debt funds depending on when you need the money or how you have timed your goal. They are generally more stable than equity investments, but they are still sensitive to factors like inflation, interest rates, and credit risk. If you invest in debt funds for a shorter period, you might face volatility, especially if interest rates change suddenly. However, if you commit to a longer-term investment in debt funds, they tend to be more insulated from these short-term fluctuations, and the steady interest accrual over time usually leads to a more predictable and favorable return. This makes long-term debt fund investments a safer option for those seeking stability.

Generally for equity funds, the shorter your tenure of investment, the higher the risk of being affected by market fluctuations. The market might be rallying today but there is no guarantee that it will not undergo a correction the next day. If you lose sleep over market fluctuations, then investing for a longer tenure is your answer. Longer tenures are usually insulated to short term market fluctuations and in most cases culminate at a net gain. 

While FDs are considered one of the safest investment options, their returns are impacted by prevailing interest rates. If you invest in an FD for a shorter period, you may not benefit from the best available interest rates, and if rates rise after you’ve locked in your funds, you could miss out on higher returns. However, with a longer tenure, your investment becomes more insulated from these fluctuations. Over time, the returns from an FD tend to be stable and predictable, providing peace of mind and guaranteed returns, making it a safer choice for long-term financial goals.

Liquidity

Liquidity is basically how quickly you can access your funds and withdraw them. FDs, while “secure and safe,” lock you in for a fixed time period. Withdrawing prior to the maturity date can prove to be costly. Equities are liquid but often at the expense of your nerves; selling during a market correction can erode your returns.

Debt funds, however, are like a friend who’s always available. You can withdraw your investment in a maximum of T+2 working days without heavy penalties. 

For instance, Liquid funds offer same day redemption, if the redemption request is made before cut off time. These funds invest in very short-term instruments like treasury bills, commercial paper, and certificates of deposit and are designed to offer high liquidity with low risk. If the redemption request is made after the cut off time, the redemption will be processed the next day, that is T+1. 

Money market funds and ultra short term funds offer liquidity in T+1 days of filing the redemption request. This too applies only if the request is filed before cut-off time, else will take an extra day. These funds invest in instruments with slightly longer maturity periods and are ideal if you need access to funds quickly, by the next business day after the redemption request.

Exit Loads

Exit load refers to a fee or penalty charged by mutual funds, equity funds, or even some FDs when you withdraw your investment before a specified period. This is intended to discourage early withdrawals and to help the fund manage its liquidity.

FDs generally do not have an exit load. However, if you break the FD before the agreed tenure, banks may impose a penalty, effectively lowers your returns. This penalty ranges all the way from 0.5% to 1.5% reduction in interest rate. Equity funds impose an exit load when an investor redeems a part of or their entire investment before the exit load period is lapsed.This fee is typically around 1% and the exit load period is generally for a year. Short-term debt funds typically impose an exit fee of 0.5% to 1% if you redeem them within 6 to 12 months. On the other hand, ultra-short-term funds usually don’t have any exit charges. 

Taxation

Choosing different investment options can also depend on the taxation policies prevailing at the time. Here’s how the three options are taxed (Post Union Budget 2024):

1. FDs: Interest earned is fully taxable at your slab rate.

2. Equities: Long-term capital gains (LTCG) over ₹1.25 lakh are taxed at 12.5%, while short-term gains attract tax payments that are 20% of your gains.

3. Debt Funds: Debt funds are no longer short term irrespective of investment duration and are taxed in terms of long term investment as per the tax rate according to your income slab.

Why Debt Funds might just be what you are looking for

Debt funds allocate your money to bonds and securities that have high credit ratings (less likely to default). Debt funds actively manage interest rate fluctuations. So if and when interest rates are curbed in relation to prevailing market inflation, we know the price of the bond rallies leading to generous returns.

When interest rates rise, debt fund managers may shift to short-duration bonds due to fall in prices of bonds, minimizing losses. When rates fall, they shift to long-duration bonds to lock in higher returns. This amoebic quality is why debt funds are the golden goose when compared to FDs and are rather calm during equity market uncertainties.

Who Should Invest in Debt Funds?

Debt funds are for:

• Conservative investors: If market fluctuations test your blood pressure, debt funds are your financial cushion.

• Short- to medium-term planners: If you’re saving for a goal within 5 years like a vacation, or other milestones, debt funds provide steady growth without locking your money.

Bottomline

• Higher the risk, higher the returns

• Higher the risk, higher the liquidity

While debt funds are the unsung heroes of the investment world. Just like a balanced meal has carbs, protein, and fats, a balanced portfolio should consist of all three investment instruments in their right proportions. Diversifying ensures you’re not overly dependent on any single instrument, minimizing overall risk.

In the end, the right investment platter depends on your financial goals, risk tolerance, and timeline. Debt funds just might be your sweet spot if you’re looking for an option that offers stability, moderate returns, and tax efficiency.