Investors' Hangout: The best debt fund to invest now

Everybody should invest in debt funds for stability of their overall portfolio. The kind of debt funds we have - it's almost a jungle with 16 kinds of open-end funds. How do you navigate that?

Why do you need a debt fund?
Once you have decided that you have to invest in fixed income, debt fund is essential simply because you get superior liquidity and it enables a beautiful deferment - you are not liable to pay any taxes till you sell your investments. If you invest in a debt fund and you keep holding it for 10 years, you are not liable to pay taxes. You will be liable to pay taxes only when you withdraw it and only on the gains on that investment.

Over and above, compared to any comparable instrument of similar character, like fixed deposit or a bond or a company deposit, debt funds give you superior liquidity and potentially higher return. If you look at five-year and 10-year return as a long-term investment vehicle for your stable allocation, debt funds build a very strong case for themselves.

Earlier debt funds were even more attractive because you could get indexation benefit. You invested in a debt fund and held it for three years, and you could reduce your tax bill simply because it was adjusted with the cost inflation index. So only the return over and above inflation was taxable. That is gone, and despite that, I think the case for debt funds still remains very attractive. They are still the only option for people who want their money to be available on demand. But can well be a long-term investor.

Out of 16 debt fund categories, which one to choose?
Yes, there are just too many of them. And they were supposed to simplify our life. For individual investors, it was meant for the simplest of need which people have - I have some money, I want to park it and I don't want to take chances with my money, then you go for a debt fund. 16 of them are just too many. But we have a handpicked list of funds in our Premium service which you can use for your long-term fixed income investment.

I think most investors should broadly define or decide on their goal. If the money is needed in a few days or weeks, don't go anywhere beyond liquid funds or money-market funds. These are the only two categories where your money can be on demand, and you don't want any extraordinary return. But, we'll get some modest return and the money will be available and it will never go down in value.

Then money needed in a few weeks going up to a couple of years, for all those investors or medium term investors, consider short-term debt funds or ultra short-term debt funds only. This is because they will give you a relatively superior return. This is meant for all investors going from medium-term to long-term simply because you shouldn't take chances with the funds which take a call on interest rate and credit quality. These are two dimensions about which a fixed income investor should worry.

There are funds which buy long maturity bonds - bonds which will mature in 20 or 30 years. And those bonds can be very vile when interest rates go up and down. All these funds actually carry risks which are there with any fixed income.

One is that mutual funds investing in corporate bonds, they can invest in lower rated bonds in their effort to earn a little higher return. This is the kind of fund which might, on occasion, show higher return. Don't get attracted to it simply because it's just not worth your while. Many times, these funds get volatile and they are also faced with the credit risk (if a company is unable to pay its principal or interest on time, that part of the NAV will get knocked) and that is something which a fixed income or a debt fund investor is not used to. And so, that risk is not worthwhile, though it does not happen very often. But even once in a while when it happens, it could be a very painful thing because we are not ready to accept losses with a debt fund. Likewise with a long maturity bond fund. So, those are the kinds of funds which everybody should avoid. So, most investors' needs will be fulfilled with ultra short-term bond funds, liquid funds and short-term bond funds, that's it. That is where your needs end and they fulfil most of it.

What to do for absolute safety?
If you want absolute safety, your options are liquid fund, money-market fund or deposits. I feel that money-market funds are superior to fixed deposits even in terms of safety. Sometimes they might yield a higher return or a little lower, but in terms of safety, they are higher than a bank deposit simply because the way money is invested in multiple banks, that is also spreading your risk. So on that count, I think those funds qualify as superior instruments than a single bank fixed deposit.

Then comes the kind of difference. Let's just take a comparison of one-year fixed deposit in SBI that will earn you 6.8 per cent and if you have a deposit of Rs 1 crore, you will earn 6 per cent as compared to a short maturity fund where you'll earn little more (7.61 per cent or whatever), about close to 1 per cent more. This will translate into Rs 80,000 difference, which might be quite meaningful.

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This article was originally published on June 23, 2023.