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Diversification is the soul of investing. We often hear experts say, “don’t put all your eggs in one basket”. The sole premise of diversification is to reduce your investment risk. Debt is the other major asset class that helps you diversify your investment portfolio. Investors who want to stay away from the stock market volatility and have a low appetite for risk may consider investing in debt mutual funds. Debt as an asset class is less volatile and helps give stability to your portfolio.

An overview of debt funds
A debt fund is a mutual fund scheme that predominantly invests in fixed-income instruments, such as government securities, corporate bonds, corporate debt securities, treasury bills and money market instruments of varying maturities. There are both long term and short-term debt funds available for catering to different investment horizons as well as liquidity preferences of investors. The debt mutual fund tends to generate a fixed income or returns. One of the main reasons why investors choose a debt fund is because of its relatively stable returns.

Benefits of investing in debt funds
A debt mutual fund investment offers diversification, better liquidity as investors can easily withdraw their investments at any time. Investors can also make partial withdrawals if needed. The process of redemption in the case of mutual funds is easier. Investors can exit at their discretion without having to pay a penal interest /charge. Unlike fixed deposits, in debt funds you pay tax only when you withdraw. Because of the deferred tax all the gains in debt funds are available for compounding.

How to choose the right debt funds
While debt funds are a safer investment option, they are not entirely risk-free. Debt funds offer a variety of products across the risk / return spectrum. It is, therefore, important for investors to select the right product according to their specific investment needs, risk appetite and investment tenure. Before we discuss how to choose the right debt fund, we should understand the two main risks in debt funds.

Interest rate risk: Bond prices and interest rates have an inverse relationship. As interest rates rise bond prices fall, and vice versa. Different fixed income instruments have varying price sensitivities to interest rate changes. The longer the duration of an instrument, the higher is the sensitivity to interest rate changes.
Credit risk: The failure to pay interest or principal by the issuer of the fixed income instrument. Rating agencies assess the credit risk of fixed income instruments based on the financial strength of their issuer and assign credit ratings to instruments. If the credit rating of an instrument gets downgraded, the price of instrument will fall. Likewise, if the credit rating gets upgraded, the price will rise.
Interest rate risk may be temporary while credit risk can be permanent
Interest rate movements are always in cycles – periods of rising interest rates are followed by periods of falling rates. If you have a long investment horizon, you will be able to ride out the volatility due to interest rate changes. However, if the issuer defaults on interest and maturity payments then the price of the instrument will be written down permanently. AMCs disclose the credit rating profile of assets for all their fixed income funds in their monthly factsheets. You should refer to these monthly factsheets to understand the credit quality of the fund before making investment decisions.

Selecting funds based on investment tenure and risk appetite
As mentioned earlier investment tenure influences your risk capacity. You should always try to match the duration profile of your investment with your investment tenure. Debt funds are available for all durations – from 1 day (overnight fund) to 7+ years (long duration fund) For investment horizon of 1 to 3 months investor can look at investing in Liquid funds. For a slightly longer investment horizon of up to a year, investors can choose Money Market and Low duration Funds which provide higher accrual. Beyond a year, Corporate Bond Funds and Banking PSU Debt Funds with high quality portfolios are ideal as besides high accruals they also provide potential capital gains. Investors who have a permanent allocation towards fixed income and do not want much duration risk should choose Short Term Bonds Funds with high quality portfolios.  For tactical calls on interest rates, investors can choose gilt funds and dynamic bond funds that match their risk profile.

In Conclusion
Despite having some limitations, debt funds still stand to be one of the best investment options for risk-averse investors who seek regular income. Debt funds serve as a great portfolio diversification tool and mitigate your mutual fund portfolio risk.

Interest rate in last 1 year has moved by ~ 300 bps. With most of the rate hikes behind us and expectation of prolonged pause and attractive portfolio YTM’s debt funds could provide attractive returns to fixed income investors as the bond portfolio could generate additional gains in form of bond price appreciation.

The author Chief Business Officer,Trust Mutual Fund, Views are personal.