Why investment scheme you choose is solely based on your income objective, risk tolerance, and investment time horizon. The reason being every investor has different liabilities, their age varies and so will their investment portfolio. Similarly, if you want to invest in mutual funds you may want to invest in equity or debt based on the kind of risks you are willing to take. Equity funds have a high risk rewards tradeoff but debt funds carry a relatively lower risk and can help you generate stable income.
Today we are going to discuss debt funds and the things to keep in mind before investing in them.
What is a debt fund?
A debt fund is a mutual fund scheme that invests in fixed income securities and money market instruments. Depending on the nature of the scheme and its investment objective, the debt fund may diversify its portfolio with corporate and government bonds, treasury bills, commercial papers, certificate of deposits, CBLO, etc.
How to choose the right debt fund?
When investing in a debt mutual fund, here are a few things to keep in mind –
Different debt funds have different maturity periods based on their investment objective. For example, a liquid fund invests in a portfolio of debt instruments that mature within 91 days. Thus, debt funds like ultra short term funds, liquid funds, and overnight funds are best suited for investors who have an investment horizon spanning from 6 months to 12 months. On the other hand, those with a long term investment horizon may consider other debt schemes like medium duration fund, long duration fund, the gilt fund with 10 year duration, etc. There is a misunderstanding among investors who feel that debt funds are only good for short term investing. However, that is not true as those who do not wish to invest in equity funds can invest in debt funds whose average portfolio maturity spans over 3 to 5 years or more.
Another common misunderstanding among a large number of investors is that mutual funds like debt funds are completely risk free. Just because the debt fund doesn’t expose its portfolio to the equity markets, that doesn’t make it an entirely risk free investment. Just like every other mutual fund scheme, debt funds have investment risks. While they may not have equity oriented risk, debt funds are prone to credit risk and interest rate risk. Credit risk is the risk of the issuers failing to pay back the loan and the promised interest within the said period. Since debt funds and interest rates have an inverse relation, a sudden spike in the interest rates might affect the performance of your debt fund especially if it has a longer maturity period.
Whether you want a direct plan or a regular plan
The main difference between a direct debt plan and a regular debt plan is the expense ratio. Direct plans can be bought directly from the AMC and hence have a low expense ratio. However, these days you can buy a direct plan from a mutual fund aggregator as well. On the other hand, regular plans offer investors with expert advice. These plans are generally sold by mutual fund agents and hence have a high expense ratio as opposed to direct plans.
Investors must not depend on debt funds for all their financial goals. They must consider spreading their investments across asset classes that will mitigate their overall investment risk and allow their overall portfolio to deliver better returns.