All you need to know about Debt Mutual Funds

Often, in asset allocation approach, debt allocation is tilted towards traditional instruments like Fixed Deposits, NSC or Time Deposits where investors earn a fixed interest. Not much importance is given to creating a portfolio through Debt Mutual Funds, which has a wide variety of schemes.

Here is how why one should allocate various debt schemes to its investment portfolio to make the asset allocation strategy more efficient.

Type of Debt Funds

1. Open Ended Funds - Like equity, there are open ended schemes where one can sell or repurchase throughout the year. Short Term Funds, Income funds, Gilt Funds, MIPs all are part of this category. These funds do not charge any entry load but there can be an exit load if funds are withdrawn within a specified time period. Generally, risk return characteristics of these funds will vary wrt. the risk of the underline investments of the fund.

2. Closed Ended Funds - Some of the debt schemes are closed ended where one can invest only during the NFO of the product and then the scheme closes for investment. The maturity happens after a specified period and the liquidity to exit is low. The only exit option to the investor is the stock exchange where these funds get listed. Fixed Maturity Plans, Capital Protection Funds comes in this category of schemes. In closed ended schemes, the risk factor is lower than open ended schemes of same tenure. This happens because investors cannot exit here and in absence of any premature withdrawal the scheme can easily hold the underline investment till the maturity.

Traditionally, fixed income investments like Fixed Deposits, NSC, POMIS etc. have been in favor due to fixed income nature. But these have been losing its sheen because taxability and inflation affect real returns. In most cases these have been lower and so it becomes important to select debt instruments considering these two factors.

Debt mutual funds scheme has two major benefits for investors:

1. Taxation- The returns form these funds are more tax efficient. Long term capital gains are taxed with benefit of indexation and tax on dividend is much lower than the income tax rate. These two combined, provides higher post tax returns for investors.

2. Returns- Investors can choose a scheme as per the time horizon and risk tolerance level. There are opportunities to earn higher returns in different market scenarios through various schemes like gilt or income funds. This helps in beating inflation which is a major factor impacting your net earnings from the scheme.

Click here to know the Best Debt Mutual Funds

What should be the allocation?

There is no predefined formula for allocation to any debt schemes. However, it has to be in line with asset allocation strategies in your financial planning. I have seen many investors taking equity exposure but avoid investing in mutual funds for their debt allocation. Rather they prefer traditional instruments because it gives them assurance of fixed returns, without realizing that they might not be earning - post tax and inflation.

So what should be the allocation in debt schemes?  Ideally it should depend on time horizon of your goals and your existing allocation. PPF and EPF are also good debt instruments for long term. But EPF is highly dependent on employment and is only for salaried. Gilt Funds are good avenues for long term goals. Some of the gilt funds have generated 10% returns in 10 years horizon. In absence of EPF these funds can form core of your debt portfolio for meeting long term goals like retirement. Then there are MIPs which have an equity exposure. Generally these are considered only for regular income generation but can be a good avenue for debt allocation. Closed Ended Funds like FMPs can form the part of your debt portfolio for meeting mid-term goals. These will yield you tax efficient returns than traditional instruments like fixed deposits. Short term funds or money market funds are ideal avenues for short term requirements like your emergency funds. The mix of these debt schemes will vary across life stages. A retired will have higher allocation to MIPs or FMPs then an individual at middle age whose requirement will be much different.

Like equity portfolio, creating a debt portfolio is also very important. It cannot happen that equities earn you higher returns but your debt portfolio is impacted because of taxation and inflation. From financial planning perspective, achievement of your financial goal hinges on how efficiently you utilized your investible surplus. So next time you do asset allocation, create a debt portfolio too after analyzing the above factors.