Debt funds are an investment option for investors looking to add stability and steady returns to their portfolios. Debt funds invest in fixed-income securities like government and corporate bonds, treasury bills, certificates of deposit, etc. Based on the maturity period of the securities they invest in, debt funds can be categorised into short-term and long-term debt funds. Aligning your debt fund investments with your financial goals is crucial. Wondering what is a debt fund and how to go about it? Read on.
What is a debt fund?
Debt funds are a type of mutual fund that invests predominantly in fixed-income securities like government and corporate bonds, money market instruments, treasury bills, certificates of deposit, etc. Based on the maturity period of the debt instruments they invest in, debt funds are categorized as short-term, medium-term, and long-term debt funds. They offer stable returns with lower volatility compared to equity funds by investing in debt instruments that offer regular interest payouts.
Short-term debt funds provide liquidity and stability
Short-term debt funds invest in money market and debt instruments with a maturity period of up to 1 year. The short duration provides liquidity, while the diversified portfolio ensures stability of returns. Short-term funds usually deliver slightly higher returns than savings accounts or fixed deposits. The returns from short-term funds range between 5-8% per annum.
Short-term debt funds are suitable for goals with duration up to 3 years. They can be used to build an emergency corpus, save for a vacation, Child’s education or make a down payment for a house. Short-term funds can also provide periodic income through Systematic Withdrawal Plans (SWPs). With low to moderate risks and easy liquidity, short-term debt funds align well with near-term financial needs.
Long-term debt funds for wealth creation
Long-term debt funds invest in government and corporate bonds, state development loans, etc. with maturity periods usually above 5 years. Long duration helps optimize returns over the long run. Long-term debt funds in India have delivered annual returns between 8-9% over the last 5-10 years.
Long-term debt funds are meant for goals with 5 years or longer time horizon. They are ideal for retirement planning, children’s marriage, accumulating a targeted corpus, etc. Long-term funds have relatively higher volatility and lower liquidity. But their power of compounding makes them a rewarding wealth creation tool for patient investors. SIPs in long-term debt funds help accumulate a large corpus through the power of compounding.
Choose between active and passive long-term debt funds
Long-term debt funds in India come in two categories – actively managed and passively managed index funds. Actively managed funds rely on fund manager’s expertise in security selection and timing. They try to outperform the market benchmarks by taking some additional risks. Index funds simply mimic a designated debt index like Nifty Bond Index with lower costs but no active fund management. Evaluate your risk appetite and expected returns to decide between active and passive long-term debt funds.
Assess your risk appetite
Debt funds carry lower risk than equity funds, but some risks exist. Interest rate changes impact bond prices and debt fund NAVs. Longer the maturity period, higher is the interest rate sensitivity. Credit risk or default risk also needs consideration. Evaluate your risk appetite and investment horizon before deciding between short and long-term debt funds.
Review portfolio periodically
Review your debt fund investments periodically to ensure they continue to match your goals. Redeem short-term funds if goals are achieved earlier. Switch to safer debt funds as the goal deadline approaches. Align long-term investments with changes in time horizon or risk profile. Make changes if required, keeping taxes and exit loads in mind.
Proper asset allocation across equity, debt and other assets is key. Seek advice from qualified financial advisors to construct a balanced portfolio aligned with your financial goals at various life stages.
Before investing in mutual funds in India, especially debt funds, evaluating factors like investment horizon, liquidity needs, risk tolerance and expected returns helps identify suitable short-term and long-term funds. Aligning investments with changing financial priorities ensures debt funds contribute effectively to achieving your financial objectives. Periodic reviews and portfolio rebalancing helps maintain the alignment over time.