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Is there always an element of risk with debt funds?

There are risks even in debt funds that investors need to understand and navigate, says Dhirendra Kumar

With the Sensex at 40,000, the markets seem hugely overvalued. Against this backdrop, is it more prudent to move the wealth created to debt funds? Also, the Franklin fiasco is getting murkier (with insider trading being reported in news through the forensic auditing). So, are debt funds really safe or is there always an element of risk?
- Sunil Jacob

I would say that debt funds are safe. But of course, the Franklin episode has happened and it is extremely disappointing. But don't go just by a one-sided story. The media have its job of looking or smelling for stories but even Franklin has come back with clarification. You can find every update that comes in the public domain, including the murkier things, on our website, as we have a running story on the homepage.

While the Franklin episode is disappointing, I think debt funds are safe by design. But they are exposed to all kinds of market risks, including credit risk, liquidity risk and the interest-rate risk. As we never witnessed these kinds of risks at a massive scale in the past, acclimatising ourselves to the changing world of increased risk in debt funds is difficult. And I think this is likely to continue. As a result, SEBI is taking steps to make debt funds more transparent and clearer. For example, you might have witnessed that the riskometer has changed. Now, it is a dynamic system which better reflects the risks. You can read my column on riskometer, which explains what it used to be and what it will be from here on. And it will be a nice starting guidance for many investors. This is because most of the time, we just look at the returns in the recent past and we go about chasing funds. That is just half the story. While risk visits you once in a while, it hits you very hard. Therefore, it is important to be aware of the risk in a consistent, comparable and an objective manner. The revised riskometer will explain that to you.
You really can't avoid risk. You have to see what level of risk you are willing to take and what you are not. The riskometer will narrate this to you much clearly. So, go with this.

To reiterate, mutual funds are safe by design but are also exposed to all kinds of market risks. But they reduce much of the risk through diversification, their management and sometimes by optimising returns. But most of the time, we are primarily guided by maximising returns and optimising returns isn't a goal and that definitely is a draw many times. So, we have to balance ourselves.

But I think debt mutual funds are relevant. One, they provide you with a very significant advantage, as they make accessible something which is otherwise not accessible to us. In India, we don't have an active bond market. So, we are left with post office saving schemes and fixed deposits. So, if you have to look for anything beyond that to optimise your return, debt funds are there. The other is tax efficiency and superior liquidity. Now, the latter advantage has come as a surprise that when a lot of investors turn up, there is a risk. But superior liquidity remains an advantage. From a tax-efficiency perspective, holding a bond fund and converting your interest into capital gains is a huge advantage. Further, with indexation, only post-inflation returns are taxed. But all of this does not really undermine that there is a risk and you have to navigate and understand it. As things are becoming clearer, invest carefully.

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