You can still make good returns from debt mutual funds

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If you are investing in mutual funds then tax is not the only factor to consider. You also have to focus on other factors like risk. After the change in tax rule and removal of indexation, debt mutual funds have lost their charm to some extent.

Although mutual fund experts believe in spite that, debt funds are still profitable. Diversification benefits are available in debt mutual funds, with lower risks, professional management, and easy liquidity.

The most important factor is your risk appetite. The return on both equity mutual funds and debt mutual funds depends on the risk the investor wants to take. Debt funds have three types of risks: credit risk (such as the risk of default in principal and interest payments), interest rate risk such as the risk of rising interest rates, and liquidity risk such as the inability to withdraw money immediately in case of need. In debt funds, liquid and overnight funds have the lowest credit risk, moderate risk in ultra-short term and short term funds, and highest in medium to long-term duration funds.

Attractive returns So, shoud you invest in debt funds in the current market scenario? Experts believe that interest rates have already peaked and inflation is also on a downward trend. Hence, debt funds with yield to maturity (YTM) can offer attractive returns to investors. This is because the rising bond prices can provide additional returns to the bond portfolio. Yield to Maturity is the return that can be earned by holding a bond until maturity.

Debt mutual funds invest in financial instruments such as mutual funds, corporate bonds, and government bonds in the money market. Bonds are instruments in which investors receive a fixed coupon rate at regular intervals and also get their principal amount back at maturity. When a bond is initially issued at a fixed price, the coupon rate is determined. If the market interest rate falls below this coupon rate, the bond becomes more attractive because it offers a higher yield than the market rate. As a result, demand for such bonds increases and their value also goes up. On the other hand, when interest rates in the market increase, the value of bonds or other fixed income securities declines, which causes the net asset value of fixed income funds that hold such securities to decrease as well.

Now, when experts estimate that there won’t be an increase in interest rates, it means the prices of fixed income securities will go up, and the net asset value of fixed income funds will increase. In other words, when interest rates start to decline, investors receive positive returns on their fixed income fund investments, and the opposite happens when interest rates increase, which could result in losses.

Tenure options

So, what are the options for investors in a debt fund? If you want to invest for a month or even less, there are many options available for you. You can invest in a liquid mutual fund and earn good returns. If you want to invest for a horizon of three to six months, there are many money market funds available. If you want to invest for a horizon of six months to one year, there are many types of short-term bond funds available.

If your risk-appetite is  moderate to medium level, then you can choose options such as PSU debt funds, corporate bond funds, gilt funds, and dynamic bond funds. Ajay Kumar Gupta, President and Chief Business Officer of Quote in Trust Mutual Fund, says that investors can achieve excellent risk-adjusted returns by investing a portion of their fixed income assets in debt mutual funds.

Choose liquid funds wisely

Now the interest on savings accounts in banks is not increasing significantly. On the other hand, returns on liquid funds are increasing. In such a situation, it would be better for you to invest your surplus cash in a liquid fund. Liquid mutual funds invest in instruments such as data and money market instruments, which have maturity of only 91 days. On the other hand, short duration funds invest in instruments such as data and money market instruments, whose portfolio duration is between 1 to 3 years.

Withdrawing money from liquid mutual funds is quite easy. You usually get the refund within one working day. If you want to invest in a debt fund for more than 2-3 years, then you should invest in a dynamic bond fund, where you can get good returns in the current interest rate environment. Dynamic bond funds are flexible in that they make changes to their portfolio according to changing market conditions. In terms of returns, liquid funds have given 5.78% in one year, ultra-short funds have given 5.3%, low-duration funds have given 5.25%, and money market funds have given 5.56%.

Experts suggest that investors should invest in selected debt mutual funds based on their short-term and long-term goals and risk-taking ability. The impact of taxes on investments should be considered as secondary and the main focus should be on choosing the right investment based on your goals and objectives. Therefore, you do not need to worry about recent changes in tax laws. If you have already invested in a debt scheme and it still fits your goals, then keep it. If an investor is looking to invest in a debt fund for the first time, they should focus on low-risk products. In case of any doubts, it is better to consult your financial adviser.