How safe are your low-risk debt mutual funds?

By: | Updated: September 18, 2018 1:24 PM

If the NAV of your debt fund turns negative, you may have to wait for much longer than an equity fund investor to turn it into positive.

MFs, mutual funds, equity funds, debt funds, equity mutual funds, debt mutual funds, bond funds, equity MFs, debt MFs, interest rate, RBI, Reserve Bank of India, economic cycle, net asset value, NAV, financial advisor, independent financial advisor, IFAs, stocks, market risks, mutual funds sahi hai, direct plans, regular plans, upar ki kamai, direct mutual fundsBut be cautious. If you buy a fund, which invests heavily in government bonds, at a wrong time, the net asset value (NAV) of your fund may turn negative.

There is a general perception that debt funds, which invest most of the money in debt instruments having fixed tenure and fixed interest rate, are safe. But be cautious. If you buy a fund, which invests heavily in government bonds, at a wrong time, the net asset value (NAV) of your fund may turn negative. Not only that, if the NAV turns negative, you may have to wait for much longer than an equity fund investor to turn it into positive. Here is how such unexpected contingency may happen.

Mutual funds are broadly divided into equity funds and debt funds. While the portfolio of equity funds comprise of minimum 65 per cent stocks, which bears high market risks, debt funds put at least 65 per cent of its investment money in debt instruments like treasury bills, government securities, corporate bonds, money market instruments and other debt securities of different time horizons that generally have a fixed maturity date and pay a fixed rate of interest.

As the stock market fluctuations affect the equity funds directly, such funds bear high risks. But debt funds are considered a low-risk investment option as they have very low equity exposure and the investments are made in instruments, which give interest income.

However, apart from interest income, returns of a debt mutual fund comprise of capital appreciation / depreciation in the value of the security due to changes in market dynamics. For example, a bond has a coupon rate of 9 per cent (coupon rate is the rate of interest paid by bond issuers on the bond’s face value). If in the subsequent year the RBI lowers the interest rates and new bonds are issued with lower interest rates, the bond with 9 per cent coupon rate will be traded in a premium rate. So there will be capital appreciation for the bond. If the interest rate is further lowered, higher will be the capital appreciation, and vice versa. The scenario will be different if the RBI hikes the interest rates. Higher than 9 per cent interest rate means capital depreciation for the bond with 9 per cent coupon rate. The higher the interest rate, the higher will be the capital depreciation and vice versa.

The RBI hikes or lowers the interest rate through various mechanisms like CRR, repo rate, reverse repo rate etc to control inflation and boost the economy. Such decisions depend upon the state of economy. So, once the interest rate is hiked by the RBI, it will take own sweet time to reduce it when the economy reaches the peak and inflationary pressure eases. As the RBI’s decision to hike or lower the interest depends upon the economic cycle, it will take years to recover, once NAV of a bond-oriented debt fund turns negative, while that of a equity fund may recover in the very next day.

So, unless you are an expert in taking investment decisions, it is always better to take advice from a financial advisor before you invest in mutual funds, be it equity or debt. In case the size of your investment is low, which makes hiring a qualified registered financial advisor out of proportion, take the help from at least an independent financial advisor, who has experience in the particular segment.

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