Do not chase higher returns via debt funds as these funds are for capital preservation.
Many believe debt funds are for those who do not want to take any risk but if you are an ultra-conservative saver who really doesn’t want to take any risks, then do not invest in debt funds. For ultra-conservative saver, it is better to stick with fixed deposits as the only risk they carry is existential risks to the banks themselves so they can stick with larger banks or banks that are too big to fail. But if you wish to properly manage your long-term personal finances and financial goals, then you can’t afford to ignore debt funds. Many think that debt funds are risk-free or like FDs but this is incorrect.
The goal behind investing in debt funds is to get a return higher than the risk-free return which we are getting. The risk-free rate would be the rate on Government Securities (G-Sec) as they are considered most secured amongst all the financial instruments. If debt funds returns are higher by 1-2%, then it makes less sense to take an additional risk as debt funds are not as secured as government-owned securities or bank FDs. The primary reason behind investing in debt funds is capital preservation and not returns, because for that we have equities where one can get more returns but with its share of risk.
Credit risk debt funds give more returns than traditional debt funds but can there be higher return without any risk? Credit risk funds are able to generate higher returns than debt funds because they invest 65% of investment corpus in less than AA-rated paper. By taking greater credit risk and investing in lower-rated papers, they produce high returns. So for the longer-term goals, the credit risk should be capped to a small exposure as it can backfire at precisely the wrong times with no scope or time for recovery or course correction.
All debt funds are not the same and have different degrees of interest or credit risk. Any individual looking for retirement should opt for safe returns like EPF, PPF and VPF and any further amount should only be invested after exhausting all safer alternative instruments. Investors should also have less exposure in credit risk debt funds because why take high risk in debt? Many investors pick debt funds based on their past returns which would have had favourable market conditions then.
These unsuspecting investors do not understand that the source of high returns is the high-risk behaviour of the fund managers that can backfire in unfavourable markets as they have invested in less than AA-rated bonds. Always remember that if debt fund is delivering really high returns compared to what its category peers are managing, then the risk is being taken.
Debt fund isn’t about return maximisation. For higher return, you need to take higher risk via equity. Debt fund is about capital preservation so don’t chase higher returns via debt funds.
The writer is director, Tradebulls Securities