Are debt funds safe?

It is a fallacy that debt funds cannot lose money. Their returns are linked to interest rate movements. When rates fall, the value of the bonds held by the mutual funds goes up, and vice versa. Interest rate cuts in the past six months have led to a rally in long-term bonds. But short-term debt funds hold bonds with a maturity of 1-2 years and are therefore not very sensitive to interest rate movements. Their earnings are primarily from the accrual of interest on the bonds they hold. Experts believe these funds will do well in the coming months. Even though we may see one or two more rate cuts, we expect short-term bonds to outperform in the coming months

In fact, smart money has been flowing into this category for some years now. The AUM of short-term debt funds has shot up in the past one year. High net worth investors are using short-term debt funds as a tax efficient replacement of fixed deposit.

Income funds, on the other hand, have a slightly longer maturity profile of 4-5 years. These funds will do well if interest rates are cut further, though experts are divided on whether the RBI will cut rates. If rates are not cut, income funds will give tepid returns. Even so, they are likely to give better post-tax returns in the 30% tax bracket. However, they may suffer some hiccups in the near term because bond yields are close to 7% now. Historically, long-term debt funds have not done too well when bond yields are so low. Go for them only if you intend to remain invested for at least 4-5 years.

When investing in a debt fund, do note that there is a small exit load (0.25-0.5%) payable if you withdraw before a minimum period. This minimum period is usually 6-12 months but can extend to 1218 months in some cases. SIP investors should note that each monthly instalment is treated as a separate investment. Let's assume that a fund charges exit load if investments are withdrawn before 6 months. If one starts a 12-month SIP in September 2016 and withdraws the entire amount in September 2017, only the first six SIPs will escape the exit load.