Why You Should Hold Debt Mutual Funds in Your Portfolio

The current environment is not conducive for many to manage their expenses with only salary or primary source of income. Moreover with inflation eroding your savings, long-term sustenance will be another challenge. This is where prudent investment planning comes into the picture. While there are numerous investment tools, such as mutual funds, are available in the market, having the right asset allocation is crucial.

If you do a random search on the internet for asset allocation, you are very likely to come across the (100 - Age) formula. For instance, if you are 30 years old, then you may have a 70% (100 - 30 yrs.) exposure to equities (as you can bear the high market risk) and 30% to other asset classes like debt and gold. In addition, given the widespread belief that equities offer higher returns, investors aim to participate only in equities, often ignoring debt funds and the important role they play in your portfolio. However, this is not the correct way of asset allocation in mutual funds. You need to evaluate your risk profile and investment horizon and ensure alignment with your financial goals.

One golden rule of smart investing is that your portfolio must always include fixed-income products, no matter what your age is or how interest rates are moving. Debt Mutual Fund's primary goal is to give investors steady income throughout the investment horizon. As mentioned earlier, inflation puts a damper on savings, leading to a loss of currency value. Debt Mutual Funds offer the potential to keep up with inflation despite the risk in your portfolio.

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Here are 6 reasons why debt funds have a key role to play in your portfolio:

1. Offers stability to your investment portfolio

Building a robust portfolio that generates significant returns requires more than just focusing on growth and wealth creation; you also need to pay attention to your portfolio's critical need for predictability and stability. Compared to equity mutual funds, depending on the sub-category, debt mutual funds are relatively stable, yield income, and are low risk. This helps provide stability to your investment portfolio, particularly during challenging market conditions as what we’re witnessing currently.

Debt Mutual Fund investments are made on securities like Corporate Bonds, Government Securities, Treasury Bills, Commercial Papers, and several other types of money market instruments. Investing in these securities is considered prudent as they generate regular income. Therefore, they are considered a smart investment option.

2. Reduces the overall risk of your portfolio

Your risk appetite does vary, and normally with advancing age and shrinking income, your risk appetite reduces. The trick is to consistently keep reducing and tweaking the average risk of your portfolio. In the pecking order of assets, equities have the highest risk, and debt funds carry much lower risk as they invest in debt products that offer predictable returns and are less volatile. For example, if you have an equity fund that has suffered losses over time, you might want to switch to a debt fund that is comparatively less risky.

3. Provides flexibility to investors

Debt Funds offer you the flexibility to move your money to other worthy mutual funds, which is possible with the help of the systematic transfer plan, i.e., STP. The STP option allows investors to systematically transfer a small portion of their money into equity at regular intervals. This helps investors to spread out the risk of investing in the equity market while holding a large corpus in debt funds with less volatility.

Debt Mutual Funds are classified on the basis of the maturity period of the underlying assets - long-term and short-term. The funds will be able to accommodate your financial needs and help you achieve your long term or short term goals accordingly. Moreover, you can invest in Debt Mutual Funds without worrying about limited liquidity or redemption options.

4. Liquidity

Debt mutual funds provide adequate liquidity, depending on the subcategory of debt fund you select. That said, it's crucial to select a debt fund who's maturity and risk profile closely fits with yours, as an investor, and not do a random selection. Investment in liquid funds under a Debt Mutual fund is thought to be ideal for an emergency fund. With a maturity period of less than 91 days, it reduces risk exposure and prioritises liquidity.

Also, it is a reliable source of liquidity nearing milestones. For instance, if you have a goal of reaching a corpus in 5 years to pay the margin for your home loan. It is hard to make money on equities in a short period of time, and hence you may have a larger allocation to debt funds if the investment horizon is short – say less than a year. You can keep growing your exposure to debt funds as the milestone draws closer, lowering your chance of loss on liquidation by the time it arrives.

5. A better alternative to Fixed Deposits

Debt Funds are the closest which comes to conventional FDs in terms of risk. Based on the selected duration, banks offer a fixed interest rate for fixed deposits. Debt fund returns, to a great extent, depend on the overall interest rate movement. They might generate moderate returns (relatively more than Fixed Deposits) in the form of capital appreciation and regular income.

Hence, debt funds normally perform better than fixed deposits by a wide margin, and given that interest rates are predicted to be close to their peaks, this is a favourable moment to invest in debt funds. Debt funds outrank FDs in a constantly evolving macroeconomic scenario and offer better benefits for investors in higher tax slabs.

[Read: Can Target Maturity Funds Be Your Alternative to Bank Fixed Deposits?]

6. Tax-efficiency

If you're seeking for ways to save money on taxes, debt mutual funds are thought of as a wise investing choice. Income from debt mutual funds is not taxable as long as you have held them for at least one year.

Today interest earned on bank FDs and corporate FDs are fully taxable in your hands at the peak rate applicable to you as per your tax slab, and return from a debt fund is classified as long and short-term. The gains on your investment are regarded as short-term gains and are subject to taxation at the rate applicable to your tax slab if you hold investments in debt mutual funds for less than 3 years.

Additionally, if you hold debt mutual funds for more than 3 years, then the gains are classified as long-term capital gains. In this case, the entire return earned over 3 years is taxed at just 20% with indexation benefits. The effective rate of tax comes to below 10% when indexation is considered, and that makes debt funds substantially more tax efficient than FDs.

These are some of the reasons why you should prefer investing in debt mutual funds and adding them to your portfolio.

How allocating to Debt Mutual Funds helps sustain amidst volatile markets?

Debt Mutual Funds did experience a turbulent period in the past few years, lurching from one crisis to another, beginning with credit defaults by ILFS and others and ending with the severe liquidity problem for Templeton debt fund investors. Owing to this, the investor sentiment was hesitant about investing in debt funds for a certain period. However, lately, debt funds have managed to stay away from controversies and negative media headlines.

The performance of the debt fund categories in 2022 appears to be not so favourable. It was sparked by factors such as rate hikes by the RBI and central banks globally, the banking system's liquidity surplus shifting from surplus to neutral, the fact that global inflation was significantly higher than average, etc. Having said that, evaluating the performance of debt funds over past one year is not the best approach. There are favourable years and volatile market phases, but over an adequate holding period, performance evens out. Moreover, Investors should also be aware that market volatility is inevitable, but if you have a long enough holding period, you can ride out market cycles.

[Read: 5 Best Low-Risk Mutual Funds to Invest in 2023]

In the year 2023, the RBI is anticipated to hold steady on interest rate decisions or any additional rate hikes, which is good news for debt funds. Debt funds will deliver accrual-based returns, which is the interest due on the various securities in the portfolio. However, do note that debt mutual funds carry market risk, interest rate risk, credit risk etc. If you are keen on a higher return from your debt funds, keep in mind that it will come with a certain degree of risk. Instead of aiming at high returns, investors should look at getting optimal post-tax returns in debt and view debt not as a wealth creator but as a source of maintaining stability in their portfolio.

As a result, depending on their investment horizon, risk tolerance, and alignment with their financial goals, investors may consider making investments in worthy Debt Mutual Funds.

MITALI DHOKE is a Research Analyst at PersonalFN. She is an MBA (Finance) and a post-graduate in commerce (M. Com). She focuses primarily on covering articles around mutual funds including NFOs, financial planning and fixed-income products. Mitali holds an overall experience of 4 years in the financial services industry.

She also actively contributes towards content creation for PersonalFN’s social media platforms in the endeavour to educate investors and enhance their financial knowledge.