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A BEGINNER’S GUIDE TO MUTUAL FUNDS

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Debt Funds Or Tradational Savings
For most Indians, traditional savings seem a natural choice, but debt funds offer variety and convenience

The primary question that comes to the mind of a new debt mutual fund investor is ‘Why should I invest in debt mutual funds when I am good with traditional debt products?’ Firstly, one may not completely move away from traditional savings but could start with some savings being shifted to debt mutual funds. The proportion would depend on one’s risk appetite and investment horizon among other things. Next, one must understand the key benefits of investing in debt mutual funds.

A major benefit of mutual funds is the variety and convenience they offer. One can invest in debt funds for even one working day to a few weeks (liquid funds) or a few months (ultra short term debt funds). There are debt funds for the medium term (short term debt funds) and long term (income and gilt funds). One may also utilise the ‘systematic’ avenues of investing in mutual funds like SIP (Systematic Investment Plan), STP (Systematic Transfer Plan) or SWP (Systematic Withdrawal Plan) all of which may not be available with traditional avenues. Another benefit of debt mutual funds is that they have the potential to offer better yields vis-a-vis traditional savings mainly due to the former’s portfolio based approach of optimizing yields across corporate and / or government bonds.

Further, one aspect of debt funds which many are not aware is that debt funds can work to your advantage both in a rising and falling interest rate scenario. As we are aware, bond returns are a function of yields (accrual returns) and capital appreciation. Further bond yields and prices move in opposite direction. Hence in case yields rise, bond prices would fall. Also, prices would fall more in case of long term bonds than short term bonds. 

Hence short term bond funds tend to benefit when yields (interest rates) rise as their bonds not only capture accruals but their prices also fall less than long term debt funds. However when yields fall and prices rise, generally long term debt funds benefit more than short term debt funds from the rise in bond prices.

While many may increase their exposure to traditional debt products when interest rates rise, they are not aware of favorable investment avenues when interest rates fall. Thus debt mutual funds provide a convenient mode of investing across time horizons as well as across interest rate scenarios.

Going further, another advantage of debt mutual funds is the indexation benefits they offer. Indexation refers to the advantage of allowing only the inflation adjusted returns to be taxed vis-à-vis the total interest earned that is taxed in case of traditional debt products. As per the latest budget presented on July 10, 2014, the government has announced that long term capital gains on non-equity oriented funds would be applicable after a 3 year holding period (earlier 1 year). What this means is that if you hold debt mutual funds for a period beyond 36 months, the tax you need to pay on capital gains would be allowed to be adjusted for inflation (indexation benefits). So if returns are 9% p.a. and inflation is 8% p.a., you pay tax only on the differential returns of 1% p.a. for this period.

This may lead to a question that if there is no tax advantage (for an investment horizon of less than 3 years), should one hold debt funds or traditional savings. The answer would be to invest as per one’s risk appetite. If one has some appetite for risk, debt mutual funds may be preferred for their potential to generate higher returns. Being actively managed, they endeavor to provide higher returns owing to two aspects – potentially better yields of the underlying debt instrument and price appreciation of these instruments, if any. However, one must note that mutual funds cannot assure returns like traditional debt products and all returns are market-linked.

SUMMARY

A major benefit of debt mutual funds over traditional products is the variety and convenience offered by the former. One can invest in debt funds for even one working day to a few weeks or a few months or even a few years by choosing the relevant type of fund. Using SIP, STP and SWP investment options provide added convenience. Debt funds are also useful for investing both in rising and falling interest rate scenarios. Indexation benefits are available for debt funds whose tenure is above 36 months.

Next To Come: Using Debt Funds For Regular Cash Flows