Understanding the role of debt funds in a diversified investment portfolio

As an investor, it’s normal to have high expectations from your investments and invest in equity funds for the best returns possible. After all, the potential of higher returns is what brings many people to stock market investing in the first place. But, with higher returns come higher risks. Market volatility can affect even the most carefully constructed portfolios and leave investors struggling to recover their losses. Here, you can balance your investment with something more stable, such as debt funds.

Debt funds are mutual fund schemes that invest in fixed income securities such as certificates of deposit, corporate bonds, T-bills, commercial papers, and other money market instruments. These funds are managed by professional fund managers who select and allocate the fund’s assets to different debt securities based on their credit rating, maturity, risk profile, and other factors.

But how do debt funds fit a diversified investment portfolio? Let’s find out.

  • Debt funds reduce volatility

Stocks and bonds are two most used investment options, but they are also negatively correlated. It means when one goes up, the other tends to go down.

By adding debt mutual funds along with equities, you can further diversify your portfolio and help to reduce the impact of market volatility. This is because debt funds’ performance is not directly related to the stock market, which means that they can provide a safety net during bear markets.

  • You can maintain stability in your portfolio

Investors who have a high-risk tolerance often invest heavily in equity funds. But, since equity funds come with high volatility, there is a risk of losing money. Adding debt funds to the portfolio can help balance out the risks and provide stability during market volatility.

  • You can move debt funds to invest in other schemes

With debt funds, you can use systematic transfer plans (STP) to transfer funds to equity funds at regular intervals. This helps you benefit from the long-term growth potential of equities and minimise the risk of market volatility without compromising on liquidity or capital protection.

  • Instant liquidity

Debt mutual funds provide more liquidity than most other types of investments, making them valuable to any portfolio. These funds are typically backed by government bonds or corporate bonds, which can be easily sold off and converted to cash, providing investors with quick access to their money. So, investors with short-term goals who may need immediate access to their funds while still looking for stable returns may find these funds an ideal investment option.

Note that some debt funds may have exit loads if redeemed before maturity period, which makes it important to plan your redemption accordingly.

How do debt funds fit into a diversified portfolio?

A well-diversified mutual fund portfolio includes a mix of different asset classes such as stocks, bonds, and cash equivalents. Debt funds can be used to add a fixed-income component to a portfolio that is heavily weighted toward equities. They can help balance out the risk of a portfolio and provide a steady stream of income to investors.

Also, you can choose from different types of debt funds that range from low risk categories (e.g. liquid funds), to high risk categories (e.g. credit risk funds). By choosing a right debt fund category and combining other asset classes in your portfolio, you can customise your strategy to match your risk appetite and investment goals.

Point to note

While debt funds are less risky than equity funds, they are not completely risk-free. Debt funds can expose investors to credit risk and interest rate risk, thus, impacting the total value of your investment.

To mitigate these risks, it is advised to research and compare different debt fund products, fees, historical performance data, and ratings from independent rating agencies. Most importantly, consult a financial advisor who can help you choose the best mutual funds as per your age, goals, risk appetite, and investment horizon.

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