The mutual fund sahi hai campaign has resonated well with retail investors over the past decade. This is reflected in the share of equity fund flows which were nearly 60 per cent of the total assets under management in November 2024. Ironically, debt mutual funds are like their poor cousin whose awareness is abysmally low. This is obvious with their abysmal 15 per cent share in the total AUM. When I mention debt mutual funds to my clients, they draw a blank. Even retail investors who are aware, often undermine this investment option as they make a flawed comparison with equity returns.
When it comes to fixed income, retail investors traditionally invest in fixed deposits, corporate deposits, post office schemes. They are not aware debt funds invests in a portfolio of fixed income products like corporate bonds, government securities, short term money market instruments like treasury bills, certificate of deposit, commercial paper.
How do debt funds generate returns?
Debt funds generate returns primarily through
- Interest income, also known as the coupon income, earned from the portfolio holdings. The interest rates are linked to the broader market and hence influence the returns. Credit rating and duration of the investments also determine the interest rates in a debt fund portfolio.
- Capital gains/losses, where change in interest rates can cause bond prices to rise or fall. Bond prices are inversely correlated with interest rates. When interest rates rise, bond prices of existing papers fall and vice versa.
Let me elaborate on the benefits of a debt mutual fund:
- Liquidity: Debt mutual funds are liquid. Most of them are open-ended funds (no lock-in) and can be redeemed anytime when the money is required. Categories like liquid funds, ultra short term and short-term debt funds investing in papers maturing in 6 months or upto 1, 2 and 3 years do not usually have an exit load. The money can be withdrawn anytime without any restrictions.In comparison, bank FDs impose penalties on premature withdrawal.
- Flexibility: Debt mutual funds offer the flexibility in terms of the amount an investor wishes to withdraw. For instance, if an investor has invested Rs.5 lakh in a liquid fund and requires Rs.2 lakh for immediate purposes, he can redeem liquid fund units equivalent to Rs.2 lakh and keep the balance amount invested. FDs do not offer such flexibility and if an investor needs money, he has to prematurely break the entire FD.
- Deferred taxation: The tax treatment for debt mutual funds and other fixed income products like FDs is the same, i.e., taxable at applicable income slabs. However, debt mutual funds allow an investor to defer tax as he pays tax only at the time of redeeming funds. In FDs, TDS (tax deducted at source) is applicable even on the accrued interest income.
How they can fit in your portfolio?
- Provide stable returns: Since debt mutual funds invest in fixed income instruments, the returns are relatively stable. Hence when equity returns are volatile in a downfall, debt mutual funds provide the much-needed stability in the overall portfolio.
- Short term needs: Debt mutual funds provide the required stability and liquidity for any short-term goals or emergency purposes. They offer the flexibility to create a separate kitty for short term requirements like travel, sudden repairs, any aspirational purchase like car, sustenance kitty for someone who is starting a new business.They are also useful for building contingency funds in the case of hospitalization, job loss.
- Systematic withdrawals: Debt funds are a suitable option for anyone who wishes to create a regular stream of monthly inflow. This is particularly helpful for retirees whose regular income stops after retirement, with liquidity and safety of capital becoming their main concerns. Retirees can withdraw a fixed amount from the invested corpus in debt mutual funds through the systematic withdrawal plan every month. SWP also proves to be tax efficient as the investor pays lower tax only on the withdrawn amount every month compared to the tax paid on the entire interest in fixed deposit.
Two things to bear in mind while investing in debt mutual funds:
- Risk involved: While debt mutual funds are not highly volatile as equity funds, they do carry risk. These funds primarily carry credit risk and interest rate risk.
- Do not look for returns: If you are investing in a debt mutual fund, it should be the for the purpose of meeting short term money requirements, contingencies and providing stability to your overall portfolio. Hankering for that extra 1-1.5 per cent would imply taking credit risk. If you are not aware, ask any retail investor who had invested in debt funds of Franklin fund house during Covid 19! If you wish to take high risk and earn high returns, take that risk in growth assets like equity over the longer term.