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Should you invest in debt funds?

Dhirendra Kumar explains how to decide whether debt funds should have a place in your portfolio and how to go about choosing one

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Debt funds have been greatly disappointing in the past few months. Should they have a place at all in a small investor's portfolio?

Dhirendra: Yes, debt funds have disappointed and we have talked about it in detail in our earlier webinars.

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Let us first ask why you need fixed income investments in the first place. Simply because they are much safer. Equity markets can go crazy but that's not the case with fixed income. It provides stability to your investments and should be embedded in your asset allocation. We even tell first-time equity investors to start with an aggressive hybrid fund because the 35 per cent allocation to debt provides stability.

The other reason you need fixed income is for goals that are due in the near term. I am talking about goals that are one, two or three years away. When you need the money in such a short span, you need to invest in fixed income.

Fixed income investments are of various kinds. Most Indians invest in bank fixed deposits. Your Public Provident Fund (PPF) Account is also a fixed income investment. Then you have many other government-backed schemes. But the problem with all such fixed income investments is that they aren't tax efficient and they don't provide liquidity. They are safe but not liquid. They also yield low returns.

This is where debt mutual funds have an advantage. They get you tax efficiency, liquidity and higher returns. Therefore, there is a place for fixed income funds in investors' portfolios. But they need to be cautious. The recent episodes of negative returns posted by debt funds should not be a reason to avoid them altogether.

So how should an investor go about investing in debt funds?
Dhirendra: Understand the risk first. Most investors get carried by the perpetual problem of chasing past performance. They simply look at the extraordinary returns given by a fund in the recent past and try to ride on it. That is where you assume risk.
Fixed income funds can turn around when it is least expected. I have seen this in the last 15 years, ever since long-term gilt funds were created. If the interest rates go down, these funds appreciate very handsomely. Suppose the interest rates fall by 1-2 per cent, 15-20 year government bond funds can potentially go up by 4-5 per cent. When investors see this kind of recent past performance, they get lured into investing in them. But inevitably, we see the tide turning after some time when the interest outlook changes and they are hit by losses.

So that should be the first rule of investing in fixed income funds. Do not chase recent past performance. If you are choosing a fixed income fund on the basis of one-to-three-year returns, avoid the top three performing funds. Don't invest in them simply because they will assume greater risk though it may not be visible. The advice to avoid the top performing fixed income fund might sound unusual to you, but it will help you avoid any nasty surprises.

Secondly, don't get into any of the exotic debt fund categories. Debt fund categories are too complicated. SEBI has defined 16 open-end debt fund categories. Besides this you have FMPs and many hybrid funds which invest predominantly in debt. Most investors should give them a pass. For most of them, just four debt fund categories are sufficient.
If you want to park your money for a few weeks or months, don't look beyond liquid funds. If you have to invest for six months to a year, choose ultra-short term or money market funds. For a longer time period, stick to short-duration funds. Don't go beyond that in lure of higher returns. For a fixed income investor, reasonable safety of capital is more important than higher returns.

How should an investor decide if he should put his money in a debt fund or not?
Dhirendra: Evaluate if it is worth taking the extra risk. I'll explain with an example. Assume you have a lakh of rupees that will remain idle for a month. You have two options to invest this money. One is to keep it in a savings bank account where you will get 3.5-4 per cent. The other is to put it in a liquid fund where the return may vary between 6-8 per cent. This additional 4 per cent return per annum on one lakh rupees for a month's time would earn you a little over Rs 300 extra. Ask yourself if you would like to assume risk, howsoever negligible, for an additional 300 rupees?

On the other hand, if the amount involved is much higher, say 50 lakh rupees, and it is idle for five to six months instead of one, the differential could be much more significant.
So understand the risk first and whether you are going to be suitably rewarded for it. Looking at the trade-offs will help you decide.

Click here to register for the forthcoming episode of Investors' Hangout and post your question for Dhirendra Kumar.

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