Debt funds: Can they provide protection and yield?

Investing can sometimes be very binary. If you want good long-term returns then you invest in equities. On the other hand, if you want to safeguard your portfolio and protect it from downside risk then you invest in debt. This binary relationship stems from our desire to generate optimal risk adjusted returns, i.e., the highest returns for a given level of risk or the lowest risk for a given level of returns. Indeed, equities are great vehicles of long-term growth and debt is a great investment for portfolio protection. However, there are some debt investments that are relatively riskier than others and consequently generate potentially higher returns. This means that certain debt mutual funds can potentially provide safety and returns. Thus, in order to truly capitalise upon the benefits of debt investments, here is a simple way to know all about debt mutual funds.

First up, let's understand what exactly are debt funds.

Debt mutual funds primarily invest in fixed income instruments like Government securities, corporate bonds, debentures, etc. Depending on the type of instrument in which they invest, the average duration of the debt investments in the portfolio, the corresponding risk profile, and the return potential will vary. Based on these parameters, SEBI has separated debt mutual fund schemes into multiple categories.

However, before we plunge into the categories, we must first define Macaulay duration.

The Macaulay duration for a portfolio tells you the time a debt scheme will take to receive cash flows from the bonds in its portfolio. It is measured in years.

The different categories of debt mutual funds are shown in the table below.

Choosing the right debt mutual fund

Considering that debt funds are available across the risk-return spectrum and investment time periods, it is important for you to choose your debt mutual fund investment judiciously. There are two things that you must remember.

• Firstly, you must ensure that your investment decision is well aligned with your overall asset allocation strategy. To achieve this, you must understand the investment mandate for each type of debt scheme. For example, is the mandate to only provide protection by investing in government bonds or is the mandate to generate higher returns by investing in corporate bonds?
• Secondly, you must also pay attention to the duration of the fund. Debt schemes are available across time periods from overnight to more than 7 years. Thus, you need to look at the risk, return potential, and average duration of the scheme before making an investment decision.

Investing is not binary in nature. Investment instruments can offer multiple benefits. It is up to us to understand these benefits and accordingly take astute investment decisions.

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