3 Myths about Debt Funds Demystified

Investors, especially those who are new to the venture are often advised to make reasonable investments in debt funds while building their portfolio. It is but natural for the new investor to wonder what ‘debt funds’ are all about and why they should at all invest in it when all the fun and returns are with the ‘equity funds’. The investment advisor will definitely shake his head and state that ‘debt funds’ are safe bets and it will provide stability to the investment kitty but striking a balance between adventure and pragmatism.

Poet T.S. Eliot asked “Where is the knowledge we have lost in information?” In this article we try to disseminate the myths surrounding ‘debt funds’ thereby providing lucidity on the subject. Every type of investment has its own pros and cons. Investors need to weigh them before acting. There are certain perceptions regarding Debt Funds which we steadfastly hold on to. It is imperative that we respond in the light of available knowledge regarding Debt Funds.

What is a debt fund?

Debt funds are mutual funds that invest in fixed income securities like bonds and treasury bills. Debt funds include various funds which invest in short term, medium term and long term bonds. Routes available for investing in debt funds are- monthly income plans (MIPs), short term plans (STPs), liquid funds, and fixed maturity plans (FMPs).

What kind of people invest in debt funds?

The key objective of investing in a debt fund is usually the preservation of capital and generation of steady income. Individuals who are un-willing to invest in a highly volatile equity market prefer debt funds. This is believed to provide steady income. The returns on ‘debt funds’ are however lower in comparison to ‘equity funds’ as by nature they are comparatively less volatile.

Perception versus reality

Per se, there are three commonly held myths regarding debt funds. Investor perceptions on the subject of ‘debt funds’ are built around these myths. We take a look at these perceptions and view them in the light of reality.

Myth I: Debt funds are risk free

It is common knowledge that any investment, whether in the nature of equity or debt, can never be totally risk free. The nature of risk however, varies between that of equity and debt funds. In case of the later, the associated risk lies in the interest rates and credit.

The price of a bond is inversely proportional to the prevailing interest rates. As interest rates rise, the price of the bond falls and vice-versa. When the maturity profile of a fund’s portfolio is high, it is exposed to greater interest rate risks.
The profile of a corporate or a financial institution has a direct bearing on its credit worthiness. This is the essence of the credit risk referred to above. When the bond issuer is known to pay interest payments timely and has the ability to repay the principal amount on maturity, it is on a good standing with low credit risk factor.

Risk on the liquidity front of the debt fund can hamper the fund’s prospects. If the fund manager invests in poorly rated debt then it can take a toll on the aspect of liquidity of the fund. This would result in difficulties when the investor needs to sell in an emergency situation.

Myth II: No negative returns from Debt Funds

It is a general belief among investors that returns from a liquid fund can never be negative. In case of liquid funds the risk relating to interest rates are not that relevant as the instruments in such portfolio have maturity tenures up to 91 days. Fund managers choose to opt for high credit rating in order to maintain a decent portfolio making it less risk prone. However, it is a fact that even liquid funds are not above market risks.

Myth III: Debt Funds require huge investments and are meant for institutions

Investors can depend on debt funds to provide a reasonable balance to their portfolio. Debt funds provide investors with an opportunity to provide stability and at the same time diversify their portfolio in different asset classes. It is a belief held in certain quarters that debt funds require huge amount of investments and are hence only suitable for institutions. This premise is only true if the investor is buying debt instruments directly from the secondary market. Small investors can make a foray into debt funds by investing as little as Rs.1000 through the mutual fund route.

Conclusion

While debt funds are definitely safer in comparison to equity funds it can be re-iterated that no market investment is beyond risk and it is financial prudence which should guide investors.