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3 myths about debt mutual funds

February 04, 2014 16:27 IST

3 myths about debt mutual funds

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Himanshu Srivastava

Debt funds are not risk-free, they can give negative returns and they are also meant for retail investors like you and me, writes Himanshu Srivastava as he debunks three commonly-held myths about debt mutual funds.

Debt funds should be part of your investment portfolio. Understanding them and not basing your decision on perception is crucial. Here we debunk some common misconceptions.

Myth I: Debt funds are risk-free

No market-related investment is risk free, be it equity or debt. The two prime risks in a debt instrument are the interest rate risk and credit risk.

The interest rate risk refers to a change in the price of a bond due to the change in the prevailing interest rate. As interest rates rise, bond prices fall and vice versa. The higher the maturity profile of a fund’s portfolio, the more prone it is to interest rate risk.

Credit risk refers to the credit worthiness of the issuer of paper -- either a corporate or financial institution. Credit risk takes into account whether the bond issuer is able to make timely interest payments and repay the principal amount on maturity.

Another type of risk to which debt funds are exposed is liquidity risk. If the fund manager invests in poorly rated debt, this could turn into a liquidity risk should the need arise for an emergency sale.

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Photographs: Dominic Xavier/Rediff.com

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Himanshu Srivastava

Myth II: Debt funds will never give negative returns

This myth is all the more prevalent in the case of liquid funds. Investors actually believe that returns from a liquid fund can never be negative.

Since the instruments in such a portfolio have a maturity period of less than 91 days, the interest rate risk does not exist to the tune it does in other debt funds. Moreover, the fund managers tend to stick to a high credit rating to maintain a very high quality portfolio which makes it less susceptible to default risk. But not for a moment are we suggesting that they are risk-free.


Photographs: Dominic Xavier/Rediff.com
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Himanshu Srivastava

Myth III: Debt funds are only for institutions

Debt funds are a good way for investors to balance their overall investment portfolio. However aggressive an investor's portfolio, an allocation to debt is always advisable, even if it is miniscule. Debt funds are a great avenue to help an investor diversify her/his portfolio into a different asset class.

Related to this is another myth that an investor would need huge amounts of money to invest in a debt fund. This would be true for investors buying debt instruments directly from the secondary market. However, if investing in a mutual fund, a big ticket size is not needed. Investors can invest in a debt fund with as little as Rs 1,000.


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