Risk-free debt funds don’t exist, but there are relatively safer categories

Dev Ashish

Recently, I was talking to a friend, when the discussion turned to mutual funds and to debt schemes. At one point, he asked me if there were any zero-risk debt funds?

Debt funds have been in news the news for a while now and not for good reasons. So, investors have questions. And they want to know more about debt funds and more importantly, the unknown-unknowns in them.

Many ultra-conservative investors are actively looking for debt funds that are totally risk free! But this perception is totally wrong. Debt funds aren’t risk free. They cannot be. They are designed to generate returns that are potentially higher than those from risk-free instruments. Hence, they will take risks. And this is how the risk-return trade-off works.

Risk-free debt funds? Sorry. They don’t exist.

Less risky debt funds

Sometime back, I wrote about avoidable financial products. This time, we will look at debt fund categories that are comparatively low-risk and can be considered by common investors.

Remember, every debt fund has some element of risk. So don’t waste your time looking for debt funds with no risk at all.

Now, risk itself means different things to different people. But in general, when investing in debt, the priority should be capital preservation and not return maximization. Why? Because, for return maximization, you have equity. And if you went with the return-maximization agenda in debt fund selections, you will be taking unnecessarily large credit plus interest rate risks, which don’t justify a few percentage points of additional returns that you get in good years.

If you really don’t want any risk at all, then stick to FDs, EPF and VPF, and PPF , as well as other government-backed small-saving schemes. They are pretty good. For others who aren’t so risk-averse and have already utilized the limit of risk-free PF kind of instruments, debt funds are still a good option.

But selecting the right debt funds is extremely important. You just can’t pick only on the basis of past returns or ratings.

Safe bets

Remember, in debt funds, it’s about safety first. Even if it comes at the cost of slightly lower returns. But as debt funds aren’t risk-free and you are looking to generate a little more than risk-free rate of return, be willing to take some credit risk and some interest rate risk. But both shouldn’t be too much.

Here are some pointers to pick debt fund categories based on timelines.

-If you are looking to park money for less than a year, stick to Liquid funds. Even the Overnight fund category is good. But it’s better for those really risk-averse. In fact, it’s better to keep money in FDs if you are considering overnight funds for less than a year. But while interest rate risk may not be a concern in both these fund categories, the credit risk has to be evaluated in liquid funds at least as the category definition doesn’t specify it.

-If the time available is more than a year but less than five years, then keep it simple and stick with Ultra Short Duration, Low Duration and Money Market Funds. These funds have very clear limitations on the interest rate risk they can take. Once again, credit risk still has to be evaluated.

-Even when investing for more than five years, Ultra Short Duration, Low Duration and Money Market Funds are decent bets. But if you wish to take some more risk, then some exposure to Short Duration Funds can be considered as well.

It goes without saying and may sound repetitive. SEBI’s category definitions do not define credit risk limits for most fund categories. So this aspect should be looked into while making your debt fund selection.

And, as a thumb rule, if you are not a sophisticated well-informed investor, stick with debt funds with shorter durations. Don’t invest randomly. The idea is to have low interest rate risk and limited credit risk.

Other pointers

Stick to funds with larger AUM from larger AMCs having low expense ratios.

Are the above suggestions sure-shot, fool-proof ways to picking perfect debt funds for your mutual fund portfolio?

Not 100 per cent. But these are still better than randomly picking and a decent approach as a base case. You will need to build up from there based on unique requirements and your risk profile. No one size fits all in debt funds or personal finances in general.

That said, debt funds still make a good case for themselves as they offer better post-tax returns and better liquidity compared to traditional fixed-income products. But debt funds selection can typically be tough if you are not careful. So, if you are unable to pick the right debt funds or for that matter are unsure whether your investments are well-suited for you and your goals, it’s always best to take professional advice.

(The writer is the founder of StableInvestor.com)