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Understanding the benefits of debt funds in a volatile market
Debt Mutual funds provide an easy option for investors to participate in fixed income markets. However, in times of market volatility, many investors shy away from debt funds citing perceived risks. But debt funds come with their own unique benefits that make them suitable even in volatile times. Read on to understand some key aspects of how debt funds can help navigate market uncertainties.
What are debt funds?
Debt funds, also known as fixed income funds, invest predominantly in debt instruments like bonds, debentures, commercial papers and certificates of deposit issued by corporates and government. The fund manager analyses the credit risk and interest rate risk of such instruments and builds a portfolio aimed at generating regular income for investors. Some popular categories of debt funds include liquid or ultra-short-term funds, short term funds, banking & PSU funds, corporate bond funds and gilt funds.
Preserving capital in declining markets
When equity markets are declining sharply due to economic, political or global uncertainties, debt funds offer capital preservation through their focus on fixed income instruments. While the nav valuations of equity funds fluctuate along with stock market movements, debt funds are less impacted as they invest in interest bearing instruments. This makes debt funds a good hedge for equity investments during volatile phases. Investors can temporarily shift assets to debt funds to minimize downside risks till market stability returns.
Regular income options
Debt funds provide regular income through periodic dividend or interest payouts, thus offering investors a steady cash flow. This makes them viable instruments for financing short-medium term requirements or to meet monthly income needs. For example, an individual nearing retirement can invest in medium to long term debt funds and rely on the periodic payouts as a source of steady income post retirement. Regular dividends also help in tax efficient reinvestment.
Interest rate movement hedging
The fund manager's active management and duration management strategy help debt funds reduce interest rate risks. When interest rates are expected to rise in the future, the fund manager can invest in short term instruments so that the portfolio matures before interest rates rise significantly. Similarly, when rates are seen falling, investments can be biased towards longer maturity bonds to take advantage of higher yields. This helps navigate changing interest rate cycles better than individual investors can.
Diversification and low risk options
Debt mutual funds offer wider portfolio diversification than direct investing in bonds due to exposure across credit profiles, maturities and industries. Multiple options across categories provide tailored solutions for different risk profiles and time horizons. For example, low duration liquid and ultra-short-term funds entail very low volatility compared to short- or medium-term funds. Individual investors can find suitable funds matching their risk-return needs.
Managing credit and rollover risks
By segregating funds across various category options with different credit profiles and maturities, the overall credit risk due to low rated issuers defaulting is diversified away. Further, well managed funds actively monitor investments and can exit exposures in companies seeing financial stress on time. They also ensure maturity profiles are spread out and not rolled aggressively at one point to mitigate bullet repayment and interest rate refixing risks. This technical risk management is difficult for ordinary investors to do efficiently.
Wrapping up
While debt fund returns may fall during periods of sharply declining interest rates, in volatile equity markets they offer relatively stable NAVs. The regular income, diversification, tax efficiency and convenience factors make them worthy instruments to hold as part of a prudent asset allocation strategy. Particularly for individuals with nearer term liabilities or income needs, debt funds deliver a well-recognized path to achieve financial goals with mitigated risks. In times of market turbulence, the proven ability of debt funds to preserve capital makes them indispensable.
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