When it comes to saving or investing, many prefer financial instruments like FD, RD, PPF etc. Because they are the safest vehicles to park one’s hard-earned money. We want our capital to be unaffected with the rise and fall of interest rates.
It is important to keep in mind the alternate avenues like debt mutual funds which also produce considerable returns. Though the degree of risk factor cannot be ruled out, investing in the right debt fund can be productive.
What are debt mutual funds?
Debt Mutual fund is a financial instrument to invest in fixed income securities, treasury bills, Government and corporate bonds, Money market etc. These funds can be open ended or closed type and the returns comprise interest income and capital appreciation or depreciation in case the market conditions are unstable.
Debt funds can be short, mid and long-term funds. You can choose the right debt fund based on your requirement.
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Understanding the risks in Debt Mutual Funds
Interest rates are inversely proportional to the bond prices which in turn affect the debt mutual funds. When borrowers default on the credit received from the company you have invested, there is a chance of increase in the interest rate. This in turn could affect the returns of the debt funds. When the interest rates fall, debt funds produce high returns.
The NAV of the fund is also exposed to change due to interest risk. If the interest rate declines, the NAV may increase in the short-term.
Government bonds carry less or virtually no risk with moderate returns while corporate bonds carry high risk with high returns. International credit agencies provide ratings for these bonds, but it is ultimately up to the investor to choose the best option. The bond with ‘AAA’ rating is considered to be a good option which has negligible risks. However, novices seeking low-risk investment can choose government bonds.
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Debt funds are also exposed to liquidity risk. If the funds are withdrawn before the minimum period or date of maturity, there may be an exit load of up to 2%. This happens when the buyer and seller are unable to find one another in a timely manner. The investor has to sell the bond below the indicated value in such circumstances.
A debt mutual fund held for more than 3 years is taxed with 20 percent of indexation while the gains form the short-term funds are added to the total income and taxed accordingly.
Having a debt fund is a good option when you want to have a diversified portfolio. Though the risk is inherent, you can benefit from debt fund if you have identified a good structure and strategy.
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