Contemplating Investing In Debt Funds? Here's All You Need To Know

In the current economic climate, short-to-medium duration debt funds with low credit and interest rate risk might be the way to go

Contemplating Investing In Debt Funds? Here's All You Need To Know

Long time debt funds would be prone to uncertainty and volatility vis-a-vis inflation

COVID-19's unprecedented impact on our economy as well as personal finances has led to many contemplating how to future-proof their investments and savings, and how to effectively build wealth for retirement. Seasoned investors and financial advisors often recommend spreading one's investments across different kinds of assets such as equities, gold, and debt. This ensures an all-weather approach that secures one's portfolio against rising inflation or any drastic movement in the value of any asset. Debt funds are considered one of the less risky investments when compared to equities, and are often preferred by investors looking for moderate, but steady returns from their investments.

What are debt funds

To understand debt funds, we must first understand what bonds are. To put it simply, bonds are loans that are taken by institutions like the government, the banks, non-banking financial companies (NBFCs), corporations, financial institutions, etc. Investors can purchase these bonds with a pre-decided date of maturity and interest rate. Since the returns are pre-calculated, these are also called fixed-income securities. Debt funds, therefore, are those mutual funds that invest in bonds, like government securities, corporate bonds, treasury bills, etc.

Returns and risks from debt funds

Since the returns from debt funds are usually immune to market fluctuations, they are considered to be safer investment options for those who have a comparatively lower risk appetite. Debt funds usually come with three kinds of risks. Credit risk is the kind of risk where the bond issuer does not repay the principal amount and interest. Interest rate risk is when the rate of interest is altered by certain factors, consequently affecting returns. And the third risk is liquidity risk where the fund house may not have enough liquidity to redeem the investments.

Can debt funds beat inflation

It is not uncommon for investors to want to secure their portfolios against inflation. Inflation is notorious for bringing down the real rate of returns of fixed-income investments. Now, going by the fact that India's retail inflation, calculated against the Consumer Price Index (CPI), has eased to 4.29 per cent in April, from what was 5.52 per cent in May, with an average of about 4.5 per cent in the five-year duration between April 2016 and March 2021, it can be assumed that the Reserve Bank of India is successful in being able to contain inflation within its upper bracket of 6 per cent. As such, most actively managed debt mutual funds have been showing returns that are seen to beat inflation.

Uncertainty and volatility

We must also keep in mind the interest rate risk with longer duration debt funds. In the current economic climate, it is difficult to ascertain if the Reserve Bank of India would maintain its interest rates or increase them. As such, debt funds that require a longer time to mature would be prone to this uncertainty and volatility with respect to inflation and consequent interest rate risk. Thus, debt funds could potentially beat inflation, but keeping in mind the economic climate, it might be prudent for debt fund investors to stick to short to medium duration funds with low credit risk and secure themselves against high-interest rate risk.