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Diversification is the soul of investing. Experts often say, “don’t put all your eggs in one basket”. The sole premise of diversification is to reduce your investment risk. Debt is a major asset class that helps you diversify your investments. Investors wanting to stay away from stock market volatility and seeking portfolio stability but having a low appetite for risk may consider investing in debt mutual 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. There are both long term and short-term debt funds catering to different investment horizons and liquidity preferences of investors.

Benefits of investing in debt funds
A debt mutual fund investment offers diversification and better liquidity as investors can easily withdraw their investments at any time, even partially. 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 mutual funds are generally low-risk investments, they are prone to risks like interest rate risk, credit risk, and liquidity risk. It is, therefore, important for investors to select the right product according to their specific investment needs, risk appetite and investment tenure.
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 and vice versa.

Interest rate risk may be temporary while credit risk can be permanent:
Interest rates are cyclical– 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 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 they offer potential capital appreciation besides high accruals. Investors who have a permanent allocation towards fixed income and do not want duration risk should choose high-quality Short-Term Bonds Funds. For tactical calls on interest rates, investors can choose gilt funds and dynamic bond funds that match their risk profile.

Debt funds are 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 1.5 year has moved by ~ 250 bps. With most of the rate hikes behind us and expectation of prolonged pause and attractive portfolio YTMs, debt funds could provide attractive returns to fixed income investors in the form of price appreciation.

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