Things to keep in mind while choosing a debt fund

in the long run InvestmentChoosing the right financial instruments is crucial to ensure that the returns generated can comfortably beat the rate of inflation. “Otherwise, the investor would unnecessarily spend a lot of money,” said Arijit Sen, SEBI registered investment advisor and co-founder of merrymind.in.

A B.Tech course in a premier institute, for example, will cost ₹15 lakhs at present but at 10% education inflation rate, the same will cost you ₹62.65 lakh 15 years down the line. “To build a fund like that within 15 years, you have to invest ₹18,000 per month if the rate of return is 8%, whereas it is only ₹12,500 if the average annual return is 12%.”

And if there is such a need, is it wise to invest in it? debt mutual fund For long term financial goals?

Diversification should be practiced from day 1

It is a completely flawed concept that one should invest in equities for the long term and debt for the short term, said Chenthil Iyer, SEBI registered investment advisor and chief strategist, Horus Financial Consultants.

“What if one’s goals are only long term, would you say that person should invest only in equities? Is it wise to put all your eggs in one basket?”

The percentage of each asset class, equity, debt, gold etc. in an investor’s portfolio should be determined by the asset allocation strategy, said Mahendra Jaju, CIO, Fixed Income, Mirae Asset Management Company, and the asset allocation should be based. on one’s risk profile, income pattern and investment horizon.

Diversification is a habit that we need to form from day one. “Even in early life, when people are not very clear about their financial goals, they should create a predictable asset allocation, which is well diversified,” Iyer said.

Debt funds are important even in the accumulation phase

It is common knowledge that when an investor is closer to their financial goal, investments should be more debt focused as they provide a cushion for riskier investments. However, even in the accumulation phase, it is equally important to have debt in your portfolio, Sen said.

“If a 40-year-old is saving for his retirement, he is still in the accumulation phase. Now, after 5 years, if the market crashes, and he does not have surplus funds to buy equity to take advantage of the situation, he can transfer money from debt to equity,” Sen exemplified.

However, the percentage of debt and equity in the portfolio depends on how close or how far you are from your investment goal.

Why Debt Mutual Fund is beneficial as compared to other Fixed Income Instruments?

When it comes to investing in fixed income instruments, most retail investors prefer FDs, PPF, etc. over debt mutual funds. This is naturally because people do not understand how debt mutual funds work, Jaju said.

Pointing out to its advantages, Iyer said, firstly, fixed income instruments, such as FDs, PPF etc, carry a huge risk which is called concentration risk. When you put money in the bank in the form of FD, if the bank fails, you lose all the money except the insurance. “But with debt mutual funds, you get the opportunity to diversify with one fund as well.”

Second, once the FD matures, the first thing that comes to mind is where to invest the money next. In case of debt funds, maturity management is handled by the fund manager.

Third, investing in debt mutual funds gives you a huge tax advantage, which adds up significantly to the entire corpus, Iyer said.

Interest is paid on maturity on investing in FDs, but you will have to pay tax on an annual basis as per your tax slab. Meanwhile, on holding a debt mutual fund for 3 years or more, the gains are treated as long-term capital gains and not interest income or income from other sources, and returns are taxed at 20%. And on top of that you get the benefit of indexation.

Explaining the concept of indexation, Iyer said, it is the adjustment for inflation that the government provides for taxing capital gains.

Suppose you earn 7% return annually from debt funds, i.e. 21% for 3 years, and meanwhile inflation is 5% p.a. Capital investment due to indexation ₹will be recalibrated as 100 ₹115. So although the profit will be ₹21, the net profit will be considered ₹6. And on that you will have to pay a total tax of 20%, that is, Rs 1.20 as tax.

Whereas for the same 7% you earn in 3 year FD ₹21 Profit, You’ll Pay Taxes in the End ₹6.2, he pointed out.

How to choose a debt fund for long term investment?

Debentures are very sensitive to interest rate fluctuations. Depending on how the interest rate moves, the price of the underlying paper can move up and down. “Hence, if there is a debt fund that is solely in long-term securities, their response to interest rate fluctuations is greater,” Jaju said.

And, this is something we need to avoid, Iyer said, adding to Jeju’s idea.

“We need to choose funds where the underlying papers do not exceed 3 to 5 years in maturity. In such cases, the interest rate volatility is less,” Iyer added.

Pointing out the other thing to keep in mind while choosing a debt fund, he said, “I personally feel, overdiversification is good for debt funds.”

A fund should have at least 50 to 60 underlying debt papers. In this way the concentration risk is reduced. Also, you need to ensure that there are 25 to 30 unique recipients for the money and none of them should have more than 5 to 10% weightage, he said.

What are Debt Funds for Long Term?

Banking PSUs and Corporate Bond Funds are the most preferred funds for the long term i.e. 3 years or more considering the current situation. It is imperative to invest these funds in high quality papers. Like banking, PSU funds can invest only in the banking and PSU sectors. And corporate bond funds will have to invest 80% in AA+ or better rated paper, Jaju said.

“Also, they have the flexibility to reduce/extend the duration depending on how interest rates are moving.”

There is another category for the long term – ie gilt funds – but they tend to be very volatile. So, if you buy it, in that case, it should be a mix of Gilt Fund, Banking PSU Fund and Corporate Bond Fund.

While investing in debt mutual funds, most investors focus only on the returns or the associated risk. All investments should be based on the broad structure of the portfolio. So, while choosing a debt instrument rather than any investment, make sure it is in line with your investment goals.