How Can Debt Funds Help Diversify Your Portfolio?

How Can Debt Funds Help Diversify Your Portfolio?

FPJ Web DeskUpdated: Wednesday, March 20, 2024, 12:50 PM IST
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How Can Debt Funds Help Diversify Your Portfolio? |

New Delhi (India): Debt funds deliver portfolio diversity and steady returns without equity volatility, tying growth to unpredictable sentiment. Their structure also offers tactical liquidity benefiting households and institutions alike. In this article, we will learn how fixed income allocation helps meet objectives reliably regardless of external uncertainty.

An Overview of Debt Funds

Debt funds invest in debt securities to target a steady stream of interest income over time. They are more stable than equity assets and offer downside protection during volatile market conditions. Quality debt issuers commit to regular interest servicing and principal repayments, protecting bondholders' invested capital.

Four Core Benefits Driving Debt Fund Allocations Opportunistically

1. Portfolio Diversification with Lower Correlations

●     Debt securities demonstrate lower price correlation with stocks, REITs, etc., which nicely diversifies holdings.

●     Adding bonds offsets overall portfolio volatility versus capital growth overweight strategies underexposed to fixed income streams.

2. Stable, Reliable Cash Flow Harvested Over Time  

●     Interest income accrues predictably sans emotions of the equity rollercoaster tied to external events and company performance fluctuations.  

●     Reasonable absolute returns still accumulate, meeting reserved investor preferences despite higher inflationary regimes.  

3. Liquid Access Providing Cash Optionality  

●     Compared to physical bonds, units of debt mutual fund schemes trade openly on stock exchanges, allowing liquidity akin to share markets, enabling swift exits.

●     Urgent access aids households requiring sizable redemptions in navigating goals like school fees or home purchases using sunk accumulated corpus without disruption or penalties.  

4. Lower Risk Choice Over Volatile Equities 

●     Conservative investors with minimal risk appetite beyond capital preservation find a safe harbour for surplus savings by allocating partially toward higher-quality debt. 

●     Principal protection takes precedence over maximising fickle capital gains that are highly susceptible to periodic cycles beyond investor control anyway.   

Three Central Risk Types to Consider Around Debt Funds 

I. Interest Rate Risks Impacting Net Asset Values

As rates trend upwards, the attractions of newly issued bonds at higher coupons lure investors away, applying selling pressure on existing lower-yield bond funds units. Consequently, bond prices fall to equalise their overall holding period return. 

This phenomenon explains the inverse relationship between prevailing bond yields and underlying bond valuations. This impacts debt fund unit NAVs (net asset value) representatively.  

II. Credit Risk From Issuer Defaults on Obligations

Debt funds also carry the risk of financial loss arising from any failure of the bond issuer to uphold original repayment obligations due against principal or interest payouts scheduled on invested papers. These defaults, although relatively infrequent, expose investors nonetheless. 

Careful evaluation of credit rating quality by reputed agencies offers prudent guardrails mitigating risks associated with higher yield returns, insufficiently compensating for flimsier issuer profiles vulnerable to business downcycles or sectoral headwinds. 

III. Liquidity Risk During Market Panics

Open-ended mutual fund investments are traded freely on stock exchanges, allowing investors to exit based on a balance between buy and sell trading interest. This balance ensures healthy spreads, efficient pricing, and smooth capital flows. However, sentiment-driven panics can disrupt this balance, causing a lack of liquidity and forcing investors to suffer losses. 

Therefore, careful evaluation of scheme portfolio assets is necessary, and investments in reasonably tradable bonds or securities priced transparently can help to minimise vulnerability.

Tips for Finding the Right Debt Fund

Selecting appropriate debt mutual funds aligned with personal financial situations proves pivotal. Yet, many discover myriads of products that are overwhelming initially. By evaluating key factors systematically, ideal matches emerge from crowded fixed-income investment markets populated with assorted options catering to varied objectives.

1. Clarify the Core Investment Objective

●     Wealth preservation – Parking surplus savings in highly liquid funds keeps capital defensive.

●     Income generation – Locking some corpus into bonds/bills over 3-5 years collects interest earnings regularly.  

●     Retirement provisioning – Long-duration government bond funds accumulate structured payouts.

2. Determine Investment Tenor Horizon Comfortably

●     Short-duration funds hold <1yr securities facilitating tactical parking awaiting reinvestment. 

●     Medium duration funds range from 1-4 years, suitable for predictable near-term expenses.

●     Long-duration funds exceed 4 years of holding bonds matching long-term investing outlooks.

3. Risk Appetite for Potential Default Losses

Higher-rated issuers demonstrate reliable credit quality, while weaker counterparts warrant risk premiums compensating probable capital losses upon potential defaults. Consider the risk parameters below:

●     Highest safety – Government securities carry negligible default risks inherently followed by AAA bonds. 

●     Moderate risk – AA category corporate bonds increase the probability of defaults marginally.  

●     Higher risk – A or below-rated securities further elevate default risks balanced by higher returns.

4. Assess Interest Rate Cycles Impacting Bond Valuations

Rising rate regimes depress existing bond valuations as newer issues offer richer coupons attracting investors. The inverse relationship between prevailing yields and underlying bond values causes periodic mark-to-market fluctuations in debt funds values linked to rate cycles dynamically. However, adjusting entry/exit alignments with rate trends over holding periods offsets interim NAV changes reasonably.  

5. Evaluate Portfolio Positioning for Balanced Allocations  

Debt mutual funds diversify concentrated equity allocations vulnerable to downside corrections over market cycles. They stabilise overall portfolio volatility when supplemented strategically alongside other assets like stocks, gold, or real estate. Consider appropriate ratios between debt and growth avenues corresponding to individual risk parameters that warm portfolios reliably during uncertain times.

Conclusion

Debt mutual funds are an excellent option for investors looking for steady returns and stability. These fixed-income investments can preserve your capital and offer protection against market volatility. Debt funds are particularly advantageous in helping you achieve your financial objectives while safeguarding against unpredictable market conditions. For expert guidance on choosing the investment product that best suits your needs, look no further than Aditya Birla Sun Life Mutual Fund Schemes.


Disclaimer: This is a syndicated feed. The article is not edited by the FPJ editorial team.

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