Debt funds better than company FDs

Investing in the market has always been synonymous with investing in mutual funds, preferably, those that have managed to yield good returns in the past. Most risk-averse investors prefer to put their money in a range of debt products including fixed deposits, recurring deposits, government bonds, company deposits, etc. There is a popular misconception that debt instruments are the same as debt funds. Also, there is a lack of adequate knowledge about debt funds and how the right kind of them can be chosen to create wealth. This has led to zero or minimal investments in debt funds. 

First-time investors often ask if there is any credit risk associated with investments in debt funds. Any debt fund one buys is actually a collection of a varying range of debt instruments. Suresh Sadagopan, founder, Ladder7 Financial Advisories, says, “It depends on the underlying papers and their credit rating. If the credit rating of papers is low or if some of the papers are from companies which are stressed and the credit rating would consequently come down, then that fund will have credit risks.” This is because the debt funds, unlike debt products, can yield negative returns too. This can be due to the adverse interest rate movements due to which there is a NAV drop or the value can erode due to defaults in interests or principal in some of the papers that the debt fund is holding.

Should you invest in debt funds? 

Investing in debt funds and including them as an essential element of your financial portfolio is important. This is because the multiple debt securities with their myriad maturity dates and interest rates help in diversifying risks as the positive yield on one balances out the negative yield of the other. Sadagopan says, “There is a fund manager and his team who manage the fund and the risks all the time. There are all kinds of funds which one can choose from based on asset quality, duration, type of holding etc. It is also more tax efficient, especially if held for over 36 months. Hence, a debt fund is actually better in a lot of ways as compared to a direct investment in FD in a company.”

Opt for long-term debt funds

How long you wish to stay invested has a determining effect on the time horizon of your debt funds. Many people buy debt funds only to protect themselves against losses due to the undulating movements of the stock market. However, preferring the long-term debt funds over their short-term counterparts ensures that your dreams of earning good returns from the market are gradually realised over the period. Vineet Patawari, co-founder, stock analytic app StockEdge and financial market learning portal Elearnmarkets.com, says, “Risk and reward for an investor are impacted by the tenure of the fund. For funds with a maturity of greater than three years, you get indexation benefit for tax calculation, which results in better post-tax yield.”

Size matters while diversification helps 

Small-cap equity mutual funds earn returns over a period but involve a lot of risks. This explains why risk-averse investors looking for moderate returns without being affected by sudden market movements prefer mid-cap and multi-cap mutual funds. Diversity acts to hedge debt funds from sudden market movements and fluctuating bank rates. Hemant Beniwal, Sebi registered investment adviser, The Financial Literates, says, “Theoretically small funds should be easy to manage and exit securities in difficult times. But in reality, the size of the fund depends on the performance of the fund manager and trust in the processes of the asset management company. Larger funds are preferable as they give bargaining power to the fund manager to make better deals. Larger funds are normally better diversified and that reduces risk.”

Assessing your debt fund scheme

Investing blindly does not make sense. Before paying for any fund, it is always worthwhile to look at the stocks held by various mutual funds. Beniwal says, “It's important that one should understand the category of the fund one is investing. So if you don't want to take credit risk, avoid credit risk funds and stick to the corporate bond category or medium-term funds. Even in that case risk can't be totally eliminated, investors can add two more filters. Funds must be well diversified, a single company should not have exposure of more than 5% at any time. Investors can consider funds that limit investment from a single investor - such funds avoid corporate money. Corporates are first to exit when there's any uncertainty and that reduces the quality of funds portfolio because fund managers sell better quality and more liquid assets to meet redemption pressure.”

Past results don't matter

It's common to look at the past returns of stocks and mutual funds to gauge its probable performance in future. Some mutual funds are preferred over others due to their past records of high returns in sync with the market returns. However, long-term track records are not enough to judge the quality of debt funds. Sachin Jain, analyst (MF), ICICI Direct, says, “The historical way of evaluation debt funds by focusing on YTMs, AUMs, historical return, AMCs, etc. need a drastic change. The evaluation now needs to be more focused on the individual holdings and evaluation of those holdings in terms of their business profile, industry outlook, their cash flow management, diversification, etc. Evaluation of a debt fund needs an expert opinion on each of their portfolio holdings to identify the potential credit risk involved.”

A practical approach

All things said and done, laymen often find it difficult to assess the quality of a debt fund before investing in it. Sabyasachi Mukherjee, head of research and international products, Karvy Private Wealth suggests a more practical approach. Mukherjee, says, “A well-diversified portfolio with exposure of not more than 5? in a single security and 10% in a single group with at least 80% AAA rated paper and low exit load should be the basic parameters to select a debt fund.”