4 questions on your debt portfolio answered

By Larissa Fernand |  07-01-22 | 

In the ongoing bull run, investors tend to ignore the debt allocation of their portfolio.

Equity and fixed-income asset classes are inherently different in terms of their risk-return profile. Equities have the potential to deliver superior inflation-adjusted returns compared to fixed-income over the long term. They are the most favoured asset class for wealth generation over the long term, and should form a part of an investor’s portfolio subject to his/her risk appetite. But debt investments offer stability to the portfolio.

During certain phases, one asset class may appear dispensable. Don’t fall for that narrative. In a rampant bull market, you may question why you are invested in debt. In a brutal bear market as we witnessed in the first half of 2020, you may want to flee equity altogether. Don’t act on your impulses.

The bedrock of a portfolio is suitable asset allocation. The asset classes must complement the other, not compete with them. Depending on a host of factors, you will have to arrive at your own equity and debt allocation. You then work within that framework.

Here are questions we are frequently asked.

Can debt funds be part of an Emergency Fund?

When it comes to an Emergency Fund, the focus is safety and capital preservation, liquidity and quick accessibility. This eliminates fixed-return investments such as Public Provident Fund (PPF), Employee Provident Fund (EPF), convertible debentures.

The Emergency Fund is not a wealth creation avenue. So returns must take a backseat, and volatile investments must be avoided. Avoid stocks and equity mutual funds. You may need the money during the depths of a bear market and would be forced to sell investments at a huge loss.

Liquid and Overnight funds meet the prime requirements of safety and liquidity. Both are open-ended debt fund categories that invest in high credit quality instruments entailing minimal credit and duration risk. Both types of funds have portfolios diversified across high credit quality instruments with minimal duration risk. They are typically accessible within T+1 days (T being date of redemption).

Your Emergency Fund can have the above debt funds and a bank deposit too. It need not be one to the exclusion of the other.

Related Reading: 4 things an Emergency Fund is not

Are PPF and EPF part of the debt portfolio?

A debt investment is one that offers a fixed return to the investor with a promise to repay the principal over a predetermined tenure. There are variations but this is the broad premise. Going by that definition, both the EPF and PPF are debt investments – an assured rate of return, and the principal will be returned over a predetermined tenure.

So yes, they are both part of the debt portfolio. BUT, they cannot be the only part of your portfolio. The reason being that both these investments have very long lock-in periods, and premature withdrawals are applicable only for specified and predetermined situations.

They score on safety since they are both backed by the government. They have an assured return. But liquidity is not their strong point. To compensate, debt funds must form a part of your portfolio.

Covered in more detail: What must your debt portfolio comprise of?

Can a debt SIP be a viable alternative to a Recurring Deposit?

The structure of an SIP is that it works best for a volatile asset class such as equity. But that does not stop you from doing an SIP into a debt fund. Additionally, debt funds are tax-efficient if held for over 3 years, with the gains being taxed at 20% (excluding cess and surcharge) after indexation of purchase price. The indexation of cost results in the net tax to be paid on gains to be less than 20%. On the other hand, interest earned on recurring deposits is taxed at the marginal rate and does not offer any indexation benefit.

In the article mentioned below, an example is provided. Let’s say you did a monthly systematic investment plan, or SIP, of Rs 10,000 in the Nifty 10-year Benchmark G-Sec Index and a similar amount into a bank recurring deposit for the 10 years ended December 31, 2020. For the bank deposit, the data used was that of SBI quarterly fixed deposit rates. The annualised XIRR would be 7% (recurring deposit) compared to 7.7% (G-Sec Index).

Swarup Mohanty, the CEO at Mirae Asset Mutual Fund, explains that “When you invest with a medium to long term perspective, debt instruments generate stable returns. In fact, sometime in 2019-20, the 10-year returns of G-Secs were higher than the Nifty.” So yes, there is the potential to earn higher returns, coupled with the tax benefit.

Covered in more detail: Should you do an SIP into a debt fund?

Are debt funds a substitute for fixed deposits?

If you are an ultra-conservative saver who really doesn’t want to take any risks, steer clear of debt funds. Stick with bank fixed deposits. The assurance you get from it will not be available with a market-linked product. The exact tenure of the investment and the return is made clear upfront.

Having said that, don’t fall for false narratives such as ‘debt funds are like FDs’ and ‘debt funds are risk-free.’ These are grossly incorrect and misleading. No market linked investment, be it debt or equity, is ever risk free.

The risk you would face with a bank fixed deposit is the existential risk to the bank itself. But if you stick with the systematically important and too-big-to-fail larger banks, you are on solid ground.

More articles on Debt Funds

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Daniel DSouza
Jan 8 2022 07:12 PM
 Fixed deposits are great when you know when the funds will be needed. But with more flexible requirements, debt funds have a significant advantage -- you keep earning without having to do anything.
The same logic applies to emergency funds also, not to mention the tax benefit as an emergency fund may not be utilised for years.
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