Home Debt instrument Things to keep in mind when choosing a debt fund

Things to keep in mind when choosing a debt fund

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In long-term investments, choosing the right financial instruments is essential in order to ensure that the returns generated can easily beat the rate of inflation. “Otherwise, the investor would end up spending a lot more money unnecessarily,” said Arijit Sen, Sebi-registered investment advisor and co-founder of merrymind.in.

A B.Tech course at a leading institute, for example, would cost ??15 lakh currently. But at a 10% education inflation rate the same would cost you ??62.65 lakh 15 years later. “To create this kind of corpus within 15 years, we will have to invest ??18,000 per month if the rate of return is 8%, then it would only be ??12,500 in case the average annual returns are 12%. “

And if this is the requirement, is it safe to invest in debt mutual funds for a long-term financial goal?

Diversification should be practiced from day 1

It is a completely wrong concept to invest in long-term stocks and short-term debt, said Chenthil Iyer, registered investment advisor at Sebi and chief strategist at Horus Financial Consultants.

“And if someone’s goals are only long term, would you say that person should only invest in stocks? Is it safe to put all your eggs in one basket? “

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

Diversification is a habit that we have to make from day one. “Even early in life, when people are not very clear about their financial goals, they should create a rough, well-diversified asset allocation,” Iyer added.

Debt funds are important even at the accumulation stage

It is common knowledge that as an investor approaches their financial goal, investments should be more debt-oriented as they provide a cushion for risky investments. However, it’s just as important to have debt in your wallet even at the build-up stage, Sen said.

“If a 40-year-old man is saving for his retirement, he is still in the accumulation stage. Now, 5 years later, if the market collapses and he has no excess money to buy stocks in order to take advantage of the situation, he can transfer funds from debt to stocks, ”he said. illustrated Sen.

However, the percentage of debt and equity in the portfolio should continue to change depending on how far you are from your investment goal.

Why Are Debt Mutual Funds Advantageous Over Other Fixed Income Instruments?

When it comes to placing money in fixed income instruments, most retail investors prefer FD, PPF, etc. mutual funds. Jajoo said it’s inherently because people don’t understand how mutual funds work.

Highlighting its advantages, Iyer added: First, fixed income instruments, such as FD, PPF, etc. have a major risk called concentration risk. When you deposit money in the bank in the form of an FD, if the bank goes bankrupt, you lose all the money except the insurance. “But with debt mutual funds, you have the ability to diversify even with just one fund. “

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

Third, by investing in mutual funds, you gain a significant tax advantage, which adds significantly to the overall body of work, Iyer said.

To invest in FD, interest is paid at maturity, but you must pay taxes at your tax rate on an annual basis. Meanwhile, by holding a debt mutual fund for 3 years or more, the gains are considered long-term capital gains and not as interest income or income from other sources, and the returns are considered to be long-term capital gains. are taxed at 20%. And on top of that, you get the benefit of indexing.

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

Let’s say you earn 7% return per year on a debt fund, or 21% for 3 years, and inflation in the meantime is 5% per year. Due to indexation, the capital investment of ??100 will be recalibrated as ??115. Thus, even if the gains would be ??21, net gains will be considered ??6. And on that, you would pay 20% tax, which is Rs 1.20 tax in total.

While for the same 7% you earn in 3 years FD, for ??21 winnings, you will end up paying a tax of ??6.2, he stressed.

How to choose debt funds for long term investments?

Debt securities are very sensitive to fluctuations in interest rates. Depending on changes in the interest rate, the price of the underlying securities may go up and down. “So if there is a debt fund that is completely in long-term securities, its response to fluctuations in interest rates is higher,” Jajoo said.

And that’s something we need to avoid, Iyer said, adding to Jajoo’s point of view.

“We have to choose funds whose underlying securities have no more than 3 to 5 years of maturity. In such cases, the volatility of interest rates is less, ”added Iyer.

Highlighting the second thing to look for when choosing a debt fund, he said, “Personally, I think over-diversification is good for debt funds.”

There must be at least 50 to 60 underlying debt securities in a fund. In this way, the risk of concentration is reduced. Also, you need to make sure that there are 25-30 unique recipients for the money and none of them should have more than 5-10% weighting, he added.

What are long term debt funds?

Given the current situation, over the long term, ie 3 years or more, the most preferred funds are Banking PSU funds and corporate bond funds. These funds are mandated to invest in high quality papers. As the bank PSU funds can only invest in the banking sector and PSU. And corporate bond funds should invest 80% in AA + or better rated papers, Jajoo said.

“In addition, they have the option of reducing / increasing the term according to the evolution of interest rates. “

There is another category for the long term – namely Gilt funds – but they tend to be very volatile. So even if you buy it, in this case it should be a mix of Gilt funds, Banking PSU funds, and corporate bond funds.

When investing in debt mutual funds, most investors only focus on the returns or risk associated with them. All investments should be based on the larger framework of the portfolio. So, when selecting a debt instrument, rather than an investment, make sure that it matches your investment goals.

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