Two men once stumbled upon a fortune. They felt lucky and they were very happy. This fortune was big enough to clear their debts and still be left with a decent amount. They decided to split it equally and part ways. After a while, both looked out for ways to make more money by investing their amount and strode towards more investment opportunities. The news of the stock market boom was everywhere, almost everyone was making profits from trades. News and internet articles were floating around covering stocks that were doubling investor’s money. Naturally this fuss created a euphoria around wannabe investors. Influenced by such a euphoria by the media, the first guy, excited and overbearing, bought all such “news famous” stocks without any research, and poured 100% of his money is into stocks. On the other hand, the second guy rather looked around, did some due diligence, studied and bought a few stocks, then put the remaining amount in a “less volatile, still highly liquid” investment vehicle. Fast forward to few months after, there was a sudden market crash, stock prices fell like a falling knife. The poor fellow first guy was in a big dilemma, he lost most of his money, where as the second guy had smartly diversified his fortune in equities and debt funds (the “less volatile, still highly liquid” remember?!) which had him hedged from a market fall risks.

A new investor is often an excited investor, like the first guy in our story. But one should realize there is always a chance for markets to go down, the bears can take over and one can suffer great losses. One has to strategically place funds in right place, to hedge the risks involved. One has to start slow, one should take time to study the market and slowly capitalize on opportunities. Below we discuss DEBT FUNDS, and how they can help us to lower risk and also help us grab exciting investment opportunities.

What are Debt Mutual Funds?

Debt mutual funds invest in instruments that generate fixed income like government bonds, corporate bonds, and many other money market instruments that promise secure and regular returns. They are also commonly known as Fixed Income Funds or Bond Funds.

How are they different from equity mutual funds?

While equity mutual funds invest in stocks, with stocks there is always a certain higher risk involved. The debt mutual funds focus on optimal security of returns and hence are a little safer than equity mutual funds.

When we talk about stock or equity investment, it is usually obtaining a share in a company and owning a part of it. This doesn’t promise a fixed return. Investing in a debt mutual fund means lending a sum of money to a company through the debt fund, and in turn, the company has to pay back interest and the principal amount of that loan at end of tenure. The return is fixed and more secure than equity.

How does a debt fund work?

Debt funds find opportunities to provide loans to the government and/or corporate companies. These entities or companies have a credit rating, which is used as a parameter by Debt Fund Managers to pool in a group of high-quality investment options that make up the portfolio of this fund. A higher credit rating promises surety of the returns.

However, it is also important to note that not all investments made are of the highest quality. But as the credit rating drops, the risk increases and so does the possibility of higher returns. These ratings play a very important role to understand the risk involved.

Types of Debt Funds Investors Should Look At

In India, debt funds are available in a plethora of options. These give plenty to an investor to choose from and make a well-informed decision.

1. Short-Term debt funds:

For someone looking to invest for a short period of time, say 12 months to 24 months, these are the optimal investments. These funds mostly take exposure only in quality companies that have a proven record of repaying their loans on time as well as generate sufficient cash from their business to justify the borrowing.

2. Ultra Short-Term debt funds:

Ultra Short Duration Funds are debt funds that lend to companies for a period of 3 to 6 months. Although these are low-risk funds owing to their low lending duration, they are slightly above liquid funds in the risk spectrum but still one of the lowest risk categories of Schemes to invest in.

3. Liquid funds:

Parking money to wait for good investment opportunities means trying to maintain liquidity, and for that, Liquid funds are the best bet. Liquid funds are debt funds that lend to companies for a period of up to 91 days. These are the safest funds amongst all the mutual fund categories, owing to their extremely low lending duration and they provide the most stable returns on a day-to-day basis. They can be a direct alternative to keeping money in a savings account!

4. Income Funds:

Income funds are those debt funds that are very actively managed. There is a promise of good returns. These returns are attempted to be achieved by actively trading the bonds that the fund buys. They require a high risk appetite and continuous tracking of fund. These should not be used by investors to park their money in search of better opportunities.

5. Dynamic Bond Mutual Funds:

The performance of these debt funds varies with the changing interest rates. If the interest rates are rising, then the debt funds experience a drop in returns. Conversely, in a falling interest rate cycle, the debt fund earns good returns. The risk here is no one can predict the rise and fall of interest rates and therefore it is not recommended investment option.

When is the optimal time to invest?

It is a trend for investors to retreat towards safe options when the stock market shows the first sign of falling, regardless of whether or how much it actually falls. Debt funds act as these safety nets, which might not earn the best returns when compared to equity but, are a safe bet to park money till the stock market stabilizes or is ready for a bull run.

Another option is that an investor may book profits in the stock market once they have achieved their target returns, and then those newly acquired finances can be placed in debt funds. This also provides security in case the markets fluctuate or fall. The money from the debt funds can be used again to invest in stocks at lower prices.

At any given point in time, one should never forget that – debt funds are not money makers but are like the coffers we build to retreat to on a rainy day.

Who should invest?

The Debt Fund market usually belongs to new investors and those with a low risk tolerance and impatience of returns. Debt funds offer small term investments and low-risk securities, which works perfect with the expected range of its returns.

This begs the question – why not just put all your money in the bank as an FD is the returns are low anyway?
For a simple answer, the returns on Debt Funds may be low but are still higher than FD or any other deposit returns in the bank. This also helps a person diversify their portfolio and provide liquidity in different formats.

For someone who is looking to invest more but doesn’t want to take a huge risk, debt funds act like a portal into the market.

Returns to expect

As aforementioned, Debt Funds generally offer fixed and secure returns, the only thing that makes a difference are the credit ratings of the instruments that make up the fund. The returns fall within a particular range as per the duration and type of instrument and is usually around 7-12% . Since debts are obligations, the chances of default are significantly lower. Another thing to note is the interest regime that is followed as that decides the returns.