Debt funds are not risk-free, but they can still be the right investment for you; Here’s why

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Published: May 20, 2020 11:30:38 AM

The recent debt fund debacle has put doubts in the minds of many investors. Let’s find out how debt funds are useful investments and a few things you need to keep in mind before investing in them.

mutual funds, mutual fund investment, debt funds, debt fund Tax benefits, LTCG, FD, TDS Debt fund investors are often those who have a low-risk appetite, but they want better returns than bank FDs.

Can an investment tool be completely risk-free, or is it wrong to assume so? Each investment product has one or more types of risks attached to it. The probability of occurrence of such risks plays a significant role in determining the return potential of the investment product. For example, most investors are aware that equity investments carry high market-linked risks, but they still invest in them after evaluating the best and the worst-case scenarios to fetch desired returns in the long term. Similarly, fixed deposits, debt mutual funds, real estate, and other investment products also carry risk, but the extent of risk and returns-generating potential vary significantly from one product to another.

The recent debt fund debacle has put doubts in the minds of many investors. Due to a long history of stable returns, many investors had forgotten that debt funds too carry some risk, just like any other investment instrument. If you know the limitations and risk endurance of an instrument before investing in it, you can make a better investment decision. More significantly, this doesn’t alter the fact that debt funds are still excellent investment tools that can help you in achieving your financial goals in multiple ways. Let’s find out how debt funds are useful investments and a few things you need to keep in mind before investing in them.

Tax benefits

Debt funds protect you from inflation risk through indexation benefit while calculating the tax on their long-term capital gains. Holding an investment in a debt fund for more than three years is considered long-term, and the capital gains thereof are called long-term capital gains (LTCG). Capital gains for less than three years holding are called short-term capital gains (STCG). The LTCG tax on debt funds is levied at 20% with indexation benefit, whereas the STCG tax is levied according to the applicable income tax slab rate. So, investors who fall in the higher tax bracket can save more in taxes by investing in debt funds for its LTCG benefit.

No TDS like FDs

Debt fund investors are often those who have a low-risk appetite, but they want better returns than bank FDs. So, a comparison between FDs and debt funds can clear the picture. If the interest earned on an FD exceeds Rs 40,000 in a financial year, the bank deducts a 10% TDS on it. Later you can claim the refund of the TDS amount if your tax liability is lower. On the other hand, debt funds are not subject to TDS. The investor’s tax liability on debt funds arises after taking the redemption. As such, debt funds give higher returns when the interest rate trend is downward in contrast to FDs, which provide a higher return when the interest rate trend is higher. However, do note that premature FD withdrawals attract a penalty while they also involve reinvestment risk if the interest rate falls.

Things to keep in mind when investing in a debt fund now

Before you invest in a debt fund, you must know the various risks associated with it. There are different types of debt funds available in the market, and the risks associated with them vary with each product. So, which risks should you keep in mind when selecting a debt fund?

You should keep a tab on risks like credit risk, liquidity risk, interest rate risk, and duration risk when investing in a debt fund. The recent debt fund debacle happened because credit risk was triggered due to a sudden redemption rush by the investors while the AMC in question couldn’t sell their holdings on time. Investors should be aware of the interest rate risk as well. Whenever the interest rate increases, the NAV of debt funds fall, and the investor’s returns fall simultaneously. Such debt funds that invest in assets that require long holding tenures also carry higher interest rate volatility risk.

In the prevailing situation, investing in a debt fund that holds securities for the short-term is comparatively safer. Such funds mostly invest in G-Sec or AAA-rated securities. Investors having a very low-risk appetite can also explore the Bharat Bond ETF option.

One thing is now clear to most investors — debt funds are not risk-free. That being said, another point they should understand that in debt funds, the risk can be managed more efficiently than equity funds. The right selection of debt funds as per one’s financial goals and liquidity requirements and regular monitoring of a debt fund’s portfolio allocation is also crucial.

(The author is CEO, BankBazaar.com)

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