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What is the role that debt funds play in your financial portfolio?
05 Jan 2023

If you were to do an elementary Google search for the proportion that you should invest in debt, you are very likely to come across the (100 – Age) formula. What this formula basically says is that if you are 30 years old then you must have a 70% exposure to equities and if you are 60 then you must have a 40% exposure to equity. While there is no real scientific basis to this formula, what it captures is that as your risk appetite reduces with advancing age you need to increase your exposure to debt and debt funds to reduce the volatility in your portfolio. To that extent this formula is intuitively correct in the sense that it does underscore the important role that debt funds play in your financial portfolio.

So what are the benefits of investing in debt mutual funds and why invest in debt mutual funds in the first place? Should you invest in debt funds at all, or are there better options available. Here are 6 reasons why debt funds have a key role to play in your portfolio.

1.  Gives stability to your portfolio
Your portfolio surely needs growth and wealth creation but that alone is not enough. Your portfolio also requires an element of stability that only comes from debt. When you are in debt funds your longer period returns may be lower than equities but it gives you the much needed stability and predictability to your portfolio. The component of your debt portfolio may still be small but your immediate milestones are safe due to debt exposure rather than to the more risky equity exposure.

2.  You can structure regular income on your portfolio
How do you get regular income via equities? The answer is you cannot. Equities pay dividends but there is no assurance or guarantee of the same. You can structure a debt fund as a growth plan or as a dividend plan but either ways you can be assured of regular income. Different methods of taking returns out a debt mutual fund may have different tax implications but that is off the point. What matters is that if you need regular income from your corpus, you can structure that through exposure to debt mutual funds.

3.  Reduces the overall risk of your portfolio
Your risk appetite does vary and normally with advancing age and shrinking income your risk appetite reduces. The challenge is to use debt funds to consistently keep reducing and tweaking the average risk of your portfolio. In the pecking order of assets, equities have the highest risk and debt funds carry much lower risk as they invest in assured return debt products and are less volatile. This lower volatility of debt funds makes them ideal candidates to reduce the overall risk of your portfolio.
4.  A good source of liquidity closer to milestones
This is a very interesting point. Let us say you have a target of reaching a corpus in 5 years to pay margin for your home loan. It is hard to make money on equities in a short period of time and hence you may look to have a greater proportion allocated to debt funds for this specific need. As you approach the milestone, you can keep increasing the exposure to debt funds so that by the time of the milestone your risk of loss on liquidation is almost minimal. Debt funds play a key role in balancing risk and returns as you approach your milestones.

5.  It is possible to tweak returns by tweaking risk and maturity
The beauty of debt funds is that they are extremely dynamic and flexible. Most of us tend to club all debt funds as fixed return products. That is not the case. Let us consider two instances. If you find that the risk of shifting from AAA rated debt to AA rated is not too high practically, then you can do rating-fishing by shifting to bonds with lower rating profile but with higher return potential. Secondly, when interest rates are going to fall, you can tweak your debt fund portfolio to include more funds with longer maturity so that you can get the best benefit of falling rates.

6.  Debt funds are tax efficient
Last but not the least, debt funds are fairly more tax efficient when compared to other debt products. Let us consider two such instances. Today interest earned on bank FDs and corporate FDs are fully taxable in your hands at the peak rate applicable to you. If your returns on debt funds are structured as dividends then you do not have to pay any tax on your dividend income although the fund does deduct the DDT. Alternatively, if you structure your debt fund as a growth plan and hold it for more than 3 years then it is classified as long term capital gains. In this case the entire return earned over 3 years is taxed at just 20% with indexation benefits. The effective rate of tax comes to below 10% when indexation is considered and that makes debt funds substantially more tax efficient than FDs.

The moral of the story is that adding debt funds to your portfolio not only makes your portfolio more stable and predictable, but also makes your debt exposure more tax efficient. It is not without reason that they say that gentlemen prefer bonds!

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