Debt funds are in news again. This time thanks to DHFL (You can read in more detail here). NAV (Net Asset Value) of several debt funds have plummeted in a single day. This raises a question – Are debt funds really safe? They are often pitched as an alternative to fixed deposits – with a better interest rate! But are debt funds really an alternative to fixed deposits?
(Note – Most of this assumes Indian context)
Before we begin, let us understand what are debt funds?
Debt funds, as the name indicates, invest in debt instruments. This includes government securities, treasury bills, corporate bonds and other money market instruments. These are financial instruments which offer a fixed interest rate.
Debt funds can be categorized into several categories. Some of the most common debt funds are – liquid funds, dynamic bond funds, income funds, short term funds, gilt funds etc. They differ in terms of instrument mix they invest in and maturity periods.
Most of the invested instruments have a credit rating associated with it. Higher the credit rating, higher the likelihood of the creditor returning back the money (And thus, not defaulting).
Since the debt fund lends money to different entities at pre-decided rate of interest (which in turn is based mostly on interest rates prevailing at that point of time!) the likelihood of returns, which is more or less in alignment with those rate of returns is high.
However, it is not “assured” as it i often pitched to be. There are few risks, which one should be be aware of!
What are the risks in debt fund?
There are broadly 2 types of risks in debt funds – interest risk in credit risk.
Interest risk is when the interest rate fluctuate. Typically interest rates and bond price have inverse relationship. When interest rates rise, bond prices typically fall. When interest rates fall, bond prices typically rise. (Investopedia explains this quite well).
Another risk is credit risk. This is the risk of creditor defaulting on the loan. Since the fund house lends to different entities (business, governments etc.) one or more of them not returning money can have implications on the fund value. It’s impact can be severe if there are multiple entities defaulting or if the fund’s holding in a defaulting entity is high.
Usually, the funds like overnight funds or liquid funds (which invest in instruments with short maturity period) are less riskier than likes of dynamic bond fund, income fund or gilt funds (which invest in instruments with longer maturity period)
The “fact” that debt funds are risk-free is incorrect and misleading. Their “safety” is dependent upon the safety of capital in the entities they end to. If the companies default, your debt funds doesn’t recover money and this is passed on to you. If the exposure to a certain defaulting entity is high, your investment also get exposed to higher risk!
(Related – Investment risk is everywhere!)
Should you invest in debt funds?
Despite the risks associated, debt funds in general offer a good likelihood of capital protection. If things go well, they can give slightly higher returns than bank fixed deposits.
Different types of debt funds have different risks associated with them – primarily due to nature of instruments they invest in. Liquid funds are less risky than dynamic bond funds or income funds. At the same time, potential returns offered by dynamic bond funds or income funds are more than liquid funds – but not by a great margin (potentially 1-2 percent).
Debt funds, as we discussed earlier, potentially offer returns that matches or maybe slightly higher than the bank deposits. In addition, they have an added benefit of being tax efficient. If you sell after 3 years, you get indexation benefits on debt fund & pay tax (20 percent) on profit after indexation benefit. Roughly, this is inflation adjusted cost of debt fund you have bought (so effectively profit on which you have to pay tax is less, making debt instruments tax efficient).
Are debt funds an alternative to fixed deposits?
Short answer- No.
They are different products. Yet, in terms of asset allocation both can fall under debt instruments offering capital protection. Their returns may also be similar in many cases. But they remain different products with different risks and possibilities.
Given few advantages debt funds potentially offer, you can consider investing in it – for debt part of your portfolio (assuming you have an asset allocation strategy in place).
While debt instruments do offer an advantage over fixed deposits, before you invest in, be aware of the risks – few defaults here and there, and a part of your invested capital becomes at risk!