How debt mutual funds can prove to be a boon during periods of volatility

Retail investors who are new entrants to the gamut of mutual fund investments often tend to get caught in the narrative that mutual fund investments essentially revolve around equity investments. It is only after having spent a certain amount of time or after having sought professional advice that they gain familiarity with debt funds and the importance of investing in them.

Equity investments are the indisputable leaders when it comes to generating high profits in the long run but the downside to them is that they carry high risks. It is not possible for all investors to rely on equity at all times because when market correction episodes are underway, losses may mount significantly and the lack of diversification will mean such portfolios will not have any immunity from volatility.

Market corrections can be labelled as a necessary evil and can be defined as a reduction in 10 percent or more in the prices of assets from their most recent peaks. They are essential phenomena in healthy economy. While increase in prices of assets is an indicator of the economy prospering, a continuous increase in benchmark indices could trigger high levels of inflation and market corrections help in preventing the extremes of such scenarios and the formation of market bubbles. Corrections could take place due to a wide variety of reasons – from changes in macroeconomic indicators to a structural or organizational change in a company.

Predicting and analyzing as to when a market correction can occur and till when it will last is a herculean task. For retail investors, trying to time the market is a futile exercise – you can hit the bull’s eye on a few occasions either while entering or exiting the market but the chances of acing this guessing game on both occasions is understandably slimmer. Yes, there are stories of investors having hit the jackpot in the short term by tapping into such phases but it is imprudent to turn it into an investment strategy in the conviction that similar episodes will keep playing out in the future.

Equities are the most impacted when the markets foray into the correction phase. The inclusion of investments in your portfolio which are least likely to witness a fall in their values during corrections can provide some degree of immunity from the effect of wild price fluctuations of equities. This is where debt funds can come in handy because these funds are not affected by market corrections but largely by interest rate changes.

The underlying rationale being that entities that issue bonds and shares have to make coupon payments to their bond holders, following which they have to pay taxes and then only can they gauge their profits after taxes, the dividends they can pay their shareholders or whether they can re-invest in the business, which could result in capital appreciation for shareholders. So, when uncertainty weighs heavily on the economy and the prospect of profits may dim, equities may witness a dip thus making debt funds a better bet than equities in volatile conditions.

Jitendra Agarwal, Founder of Jaipur-based Kukku Capital, an AMFI-certified mutual fund distributor says, “Allocation to debt mutual fund works to help balance the risk-return tradeoff in a portfolio especially during volatile market conditions. Debt mutual funds protect the capital and give some alpha over bank fixed deposit rates & prevailing interest dominated securities returns, while earning a promised income in the form of NAV appreciation. Hence, when the equity market undergoes a phase of correction, debt funds protect the losses and give positive returns to balance the equity portfolio losses. Debt mutual funds specially liquid & short term funds can also be used to park funds for the short term, by switching in & out from equity funds basis equity market opportunities & conditions, at the correct timing.”

In their quest to achieve growth and capital appreciation, many investors tend to overlook the necessity of injecting a fair bit of elements in their portfolios that can ensure stability at all times. Debt funds can cushion the impact on your investments when volatility is high and thus bring about predictability and safety in your portfolio. Besides considering the flexibility and liquidity advantage of debt funds, they can pave the way for the attainment of your short to medium term goals too.

Debt mutual funds also score better than equities when you want a steady stream of income from your investments. Whether you choose the growth or dividend option, you can be assured of regular income and while equities also pay dividends there is no guarantee. This can prove to a boon during market corrections when you are in need of cash and the prospect of selling your investments gives you anxiety because the market corrections have caused a dip their value and selling them would lead to heavy losses.

Key takeaways

• Simply adding debt funds to your portfolio is not enough. You need to have a clear asset allocation strategy based on which you can divide your instruments between equity and debt instruments in accordance with your risk-taking abilities.

• Debt mutual funds protect the capital and give some alpha over bank fixed deposit rates & prevailing interest dominated securities returns, while earning a promised income in the form of NAV appreciation.

• Debt mutual funds score better than equities when you want a steady stream of income from your investments

• Do not let your emotions get the better of you during periods of market correction. It is natural to feel anxious but getting carried away can unnecessarily derail your investment plans and cause your hard work to be wasted. Speak to a professional if you feel you need more clarity on your next course of action.

Disclaimer: This article is part of the HT Friday Finance series published in association with Aditya Birla Sun Life Mutual Fund.

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