Investments in Debt Mutual Funds

The recent decision of freezing six of their debt fund schemes by Franklin Templeton Debt mutual fund has sent a shock wave among the investors’ community who thought debt investments are safe and do not require any risk management. But if you see closely and analyse their investment pattern, it was an event waiting to happen. Most of their investments are done in lower-rated debt instruments to generate higher returns by compromising on safety.

Debt instruments have two risk elements associated with them,

  • Firstly, the credit risk meaning thereby payment of interest as and when due and refund of principal amount on the maturity
  • Secondly, changes in the interest rate  (due to change of repo rate as announced by RBI as part of their monetary policy)

Any investments in debt mutual funds should primarily evaluate these two factors by looking at their investment portfolio. AAA/A1+ rated debt instruments offer less credit risk as compared to other lower-rated debt instruments. So a debt mutual fund invested 100% of its corpus in AAA/A1+ rated debt instruments is a much better investment option as compared to others who compromise on the quality of their investment portfolio (by investing in lower-rated debt instruments). Most of the defaults, like the one which is under discussion are due to this reason only.
 
Changes in the interest rate due to the change in repo rate by the RBI will affect the yield delivered by the debt scheme.  Mutual fund schemes that invest in longer duration bonds are more susceptible to interest rate variations as compared to shorter-duration bonds (longer is the duration of investment more is the uncertainty of repo rate change and thus more volatility in the yield). So shorter duration debt mutual fund schemes are better as volatility is quite low and returns are steady. 
 
Conclusion

  • Before investing in debt mutual funds, thoroughly analyse the investment portfolio of the scheme. Invest only if 100% of investments are done in AAA/A1+ rated debt instruments.
  • Preference should be for shorter duration debt fund schemes.
  • Debt mutual funds are meant to provide stability to the portfolio and provide steady annualized returns of 7-8%. So please do not chase returns in debt funds. It would be at the cost of the safety of your principal.
  • Debt funds are good for investors with low-risk tolerance and provide better returns as compared to bank FD (https://letsinvestwisely.com/are-we-loosing-money-by-investing-in-bank-fd/)

Debt mutual funds carry a very low risk if chosen correctly. You can book a no-charge consultation with me on any issue of personal finance at this link (https://calendly.com/rakeshgoyal). Confidentiality is assured.

Disclaimer: Mutual funds are subject to market risk. Read all related documents carefully before investing.

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Are we loosing money by investing in Bank FD?

Rates of interest on various small saving schemes have been slashed substantially by the Government of India wef  01 April 2020.  The annual rate of interest on Bank Savings Account would be around 2.75% and Bank FDs will fetch you 5.5% to 5.8% for one to three years of term deposit. Further, interest accrued on these investments is fully taxable (except upto Rs 10000 on a savings account).

So for example, three years Bank FD having an annual rate of interest in the range of 5.8% will effectively generate a 4.06% return on investment (RoI) post taxation assuming a 30% tax bracket. With annual inflation hovering around 5% we are actually losing out on the purchasing value of our money by keeping it in Bank FD.

So, is there any option available better than keeping money in a bank fixed deposit or savings account?

Yes, investing money in debt mutual funds offer the following benefits:

* Better returns on investments (7 – 8%)
* Less tax liability, no tax deducted at source (TDS)
* Qualify for long term capital gains if remain invested for three years or more (20% tax rate with indexation benefits)
* Liquidity as good as bank account

Let’s understand this with the help of an example. For calculation purposes, let’s assume we invested Rs 5 lakh for 3 years in bank fixed deposit (RoI 5.8%) as well as in debt fund (RoI 7%).

So in the above example, we have seen that effective tax rate in debt mutual fund is half to that of bank fixed deposit and return on investment is 50% more than bank FD.

Happy Investing!!

Disclaimer: Mutual funds are subject to market risk. Read all related documents carefully before investing.