Debt funds invest the money in government or private firms’ bonds. They are fixed income instruments and hence considered to be safe like the fixed deposits. Though the risk that they carry is slightly higher than fixed deposits, it is almost negligible. Debt mutual funds are relatively safer than equity mutual funds. Debt funds are sought after by the people who want stable returns with lower risks and volatility as compared to equity mutual funds.
These funds are ideal for regular income generation and for achieving short term financial goals. Usually, earlier people preferred fixed deposits for assured returns but debt funds provide better returns with lower risks. In fixed deposits, the entire income is taxable but in debt funds, if they are held for three years, then tax is only 20% with an indexation benefit of the cost.
There is no TDS deduction for debt funds while for fixed deposits, if the interest exceeds INR 10,000 then TDS is applicable to the investment. FDs carry penalty if redeemed before the maturity date, however in debt funds, liquid funds and ultra-short term funds, if they have exit-load charges then it is only for a short duration.
Hence debt funds are safer as compared to equity funds and lie on the similar lines as FDs in terms of returns and associated investment costs.
Our general perception about mutual fund is that the equity funds carry all the risks and debt funds are safe heaven to invest in. While it is true to say that debt funds are relatively safer than equity funds, but they are not risk free like the way bank fixed deposits (FDs) are. Still debt funds are best option for an investor with low risk appetite.
The risk in debt funds comes from different sources and three most important risks are as follows:
1.An interest rate risk
The risk due to change in interest rate, where your fund manager takes wrong call on interest rates. Suppose your fund manager expects the rates to rise and managed his portfolio accordingly, but actually rates went down, your investment will be unfavourable as compared to other who took the right call in terms of interest rates.
The risk of default by the fund house or borrower. They are supposed to invest in debt fund that are rated high on investment grade by credit ratings agencies. But sometimes fund houses invest in lower rated debt papers than the safest paper in the market. The value of debt fund suffers putting a big redemption pressure, when things go wrong for the fund house.
3.Lack of liquidity
The risk of lack of market to sell funds, when you want to exit. Liquidity in non-government Indian bond market is low and fund manager may not get enough buyers to sell funds in distress.
SEBI needs to put in strict regulatory action to streamline, define and label debt funds with their correct names to make them true to label of ‘Safe’. Investment in mutual funds are assured to grow exponentially in coming years. So, requirement of continual reform and proper streamlining of funds is very vital to prevent market failures.
Debt funds are funds where at least 65% of the total corpus of the investor is invested in debt securities, including but not limited to Government Bonds, gold funds, fund of funds, and international funds. Debt funds are preferred by investors who are looking for steady income with minimal risk.
Investing in debt-oriented funds is less risky as compared to equity-oriented funds. This is because Debt funds generate a fixed return to the investor by way of interest. Interest is the reward you get for postponing your consumption, taking care of the effects of inflation on the money you get back and for the risk of the borrower not returning your money.
They are also not exposed to equity market volatility and are thus more stable in comparison.
However, it is incorrect to say that Debt-oriented Mutual Funds are totally risk free.
All Debt-oriented Mutual Funds are exposed to at least the following 3 risks:
(i) Interest Rate Risk: It represents the risk of the Fund Manager's interest rate estimations going wrong. Bond prices and interest rate are inversely related; meaning a fall in interest rate implies an increase in bond prices. However, if the fund manager's anticipation of interest rate goes wrong, your investment will perform worse as compared to others' whose fund manager took the right call.
(ii) Credit Risk: It represents the risk that the borrower will default on the payment. If your funds are given out as loans by mutual fund house to firms who default on repayment of its principal or interest, the value of the fund suffers. There have been three instances in the debt fund market in the past few years when the credit risk affected the investors' returns.
(iii) Liquidity Risk: It represents inability of the mutual fund house to meet the redemption requirements of the investors. When a borrower defaults on the payment or some adverse event occurs which hampers the liquidity of the fund, the investors are negatively affected. This is because there is lack of a markeet when you want to exit. The non-government Indian bond market is not very liquid, that is, fund managers may not find buyers if they need to sell in distress.
Though certain risks are inherent in debt -oriented funds, they are the most suitable fro investors who want to earn guaranteed returns without taking much exposure to risk.
An investor must fully understand the risks inherent in Mutual Funds and then accordingly make a decision that best meets his goals.