Why is it important to save a part of your income?

Mainly because it helps in meeting contingencies in addition to the acquisition of an asset.

Retired individuals are dependent on interest income in addition to the monthly pension for their day-to-day expenses.

In general, a layman is confused when it comes to making investments.

After all, it is his/her hard earned money that is at stake. Investors tend to look for the safety of their investments while looking for maximized returns.

Commercial banks are considered to be secured when it comes to deposits.

However, remember that you always face the interest rate risk and inflation risk. The interest rate on 1-5 years fixed deposit was 8.00% – 9.00% in October 2014.

It has fallen sharply to nearly 6.50% – 7.25% by July 2018.

This could be a problematic area for those who survive only on Interest income. 

What is the solution?

The answer is – Debt Mutual Funds

Debt Mutual Funds

The frequent, periodic reduction in interest rate motivates investors to choose alternative forms of investment i.e. moving their money into debt mutual funds.

The following table presents a comparison between debt funds and fixed deposit.

Particulars Debt Fund Fixed Deposit
Rate of returns 10-12% 6-8%
Dividend Option Yes Not applicable
Risk Low to moderate Low
Liquidity High High
Investment Option SIP or Lump sum investment Lump sum investment
Early Withdrawal Withdrawal allowed with or without exit load.

Load depends on the fund, and the period when redemption is made

A penalty is levied to withdraw prematurely
The investment expenditure Expense ratio of 1-3% No management costs

As seen from the table above, the return in debt funds is higher than fixed deposits 

This encourages an investor to invest in debt funds.

However, a word of caution is needed. Whether these returns continue to get repeated is a big question.

With declining interest rate, the yield may improve, but there is always some risk associated with it.

There is no guarantee with respect to the return on funds.

Thus, there is no assurance that the trend will be followed in the next 3-5 years. 

Does that mean one should only rely on traditional investments?

Just because debt funds are volatile in nature, it does not mean that an investor should always stick to fixed deposit and accept low returns.

Traditional instruments may be good from the risk angle, but under rising inflation, these instruments don’t prove to become beneficial.

Thus, it would be a wise decision to balance investments among traditional instruments and debt funds.

 Tips to follow and traps to avoid: Debt Funds

1. If you wish to shift from bank FDs to debt funds, don’t rely much on recent returns. Remember, interest rate volatility impacts short-term returns.

2. An investor should take into account the risk profile of the underlying instruments before making the decision to invest.

3. Individuals looking for short-term horizon should opt for liquid funds, instead of debt funds.

4. One can opt for gilt funds if he/she has a long-term horizon and has some sense of the interest rate regime.

5. Don’t ignore costs. Expense ratio remains a key factor.

6. Investors who are comfortable with some degree of risk, can invest in debt funds, which can prove to be a great parking ground for around a three-year period.

One should opt for growth option and also get tax-benefits with healthy inflation-adjusted returns from the debt funds. 

For regular income, one could opt for systematic withdrawal plans (SWP).

7. An investor needs to rebalance his/her portfolio every six months and should ideally check the performance of the funds.

In case the fund is not providing the expected return, an investor should take corrective action and switch to a better performing fund.

8. It is a well-known fact that with higher risk, returns are higher.

Thus, if you have a higher risk-taking appetite, always look to switch from debt funds to balanced funds and/or equity funds of varying market capitalization.

Some of the best debt funds are detailed here.

Feel free to connect with us should you need any assistance.

Happy Investing!

Disclaimer: The views expressed in this fund are that of the author and not those of Groww