How safe are debt funds and what debt funds should I choose?

I'm quite comfortable with equity mutual funds. However, now I want to start moving the money in fixed deposits and my savings bank account into debt funds. I'm not sure how safe debt funds are. We heard that one fund lost 7% in one day. Are there different debt funds for 6-9 months and for 3-4 years? Because I'm new to debt funds, can you suggest debt funds for me?
- Sanjeev, Delhi

Transcript: This is a question that is crossing everybody's mind simply because interest rates on deposits and small savings such as National Savings Certificates have come down. Many deposits are due for renewal and investors are faced with the prospect that money will be invested at a much lower rate.

Debt funds are relatively safer than equity funds. We talk of mutual funds in the same breath. Debt funds have nothing to do with the equity market. They invest in bonds issued by the Government and by companies which are valued differently. There are three dimensions to a bond's value. The three things I'm referring to are - maturity, issuer, and coupon. For every bond, the critical thing to check is if you will get your interest in time and if you will get your principal back. This is the guarantee we get from a bank when we make a deposit.

There are different funds for different purposes. Debt funds are safe but they are not risk-free in the way you think of bank fixed deposits. There have been one or two instances involving bond repayment but - they have been blown out of proportion. In the past, most investors have managed to recover the money in these accidents. This is not to say that there will be no such accidents in the future. When you are investing in a fund, you are de-risking yourself. Assume you invest Rs 1 lakh in a bond fund. That fund has invested in 40-50 bonds. If the company defaults, it will lose a certain percentage but not a sizeable percentage. In 99% of cases, this does not happen. There has been a handful of such cases in the last 15 years.

If a fund invests in lower-rated bonds, the possibility of defaults on its holdings arises. However, in most such cases funds do not invest 10-15% in lower rated bonds. Then there are funds which do not invest in lower-rated bonds in the first place. But those bond funds are also not very high yielding.

For liquid funds where money is on call, the average return annualizes over the past 3 years to about 7.5%. In the future, it will be 6.5%. But this is for people who are getting 4-6% on their savings bank account. This is money for a few days. For money for a few weeks or few months - an ultra short-term bond fund can get you 0.45-0.5% more.

Short term bond funds can give you 1-1.5% more. You can take your pick based on your time frame. For three years and more, I would suggest fixed maturity plans and income funds, and that you choose conservative funds. People look at past performance and invest in the best performing fund and that is where the risk might be hidden.

What about going direct and investing in bonds with the government?
No, that is not an option because the bond market is not a very active market. Here mutual funds pay a very significant role. Bond funds liquefy something that investors do not have access to. Theoretically, an investor can invest in bonds directly but the amount of money needed does not make it worthwhile.

One more thing to be kept in mind - investing in the direct plans which have lower expenses can become very meaningful. You earn 0.5%-0.75% more for an investment yielding just 7.5%-8%. Choose your fund carefully. Normally you make a one-time investment for a defined period of time. Don't get carried away by recent good performance.