Debt Funds to tackle market volatility

Due to the corona lockdown, people get the time to apply their hands in lots of new things. Some people who are away from the equity market utilize their time to understand equity and other financial instruments. The markets have been really volatile these days. There are lots of national and international events that impact the market. Even though the news is that China’s economy has started to recover, lots of other news such as surging corona numbers and the US election also impact the market. It doesn’t look like the volatility is going to go away anytime soon. If you have only equity investments in your portfolio, then this might be the time to add some quality debt funds to it. Here are the reasons why it will help you manage the market vagaries.

Strategic Asset allocation

Asset allocation is the solution to handle market volatility. The right asset allocation ensures that your portfolio has liquidity and your portfolio risk is minimized. It provides stability to your portfolio too. You can use asset allocation in many different ways, and you may already be using it without thinking much about it. For example, if you own your own home and invest in the stock market, you’re already using asset allocation even if you’re not taking maximum advantage of it.

So, from an asset allocation point of view, debt mutual funds can assist you to minimize the instability that is caused by the stock markets. Debt funds can help you maintain a diversified investment portfolio too. Investors should pick investment options based on their financial goals and the investment horizon.

Minimize risks

To curb down the risk from your assets, debt is the option to invest in. That doesn't mean, debt instruments do not have the risk attached to them. Debt is less risky compared to equity. Debt mutual funds are funds that invest in fixed income and money market securities. Debt Mutual fund underlying assets can be treasury bills, certificates of deposits, non-convertible debentures, commercial papers, bonds, Government securities (G-Secs), etc.

The main investment objective for the selection of debt funds should be income from investments and risk minimization. Investment in highly risky debt funds should be avoided. Since these securities pay a fixed interest rate, the risk of these investments is much lower than equity.

Lesser volatility

Debt funds are much less volatile than equity funds in nature. Standard deviation is an indication of volatility i.e. average deviation from mean returns. You can see this for yourself by looking at the standard deviation of these funds. The average standard deviation of short-term debt mutual funds is only 1.7%. However, when you look at large-cap equity funds and multi-cap funds, the average standard deviation of large-cap equity funds is more than 14% and 15 % respectively. Note that the volatility of mid and small-cap funds will be even higher. Therefore, when the stock markets are volatile, debt mutual funds will provide much-needed stability to your investment portfolio.

Tax benefits

Debt funds are in general more tax-efficient that leads to a lower tax liability than bank and corporate fixed deposits. Long-term capital gains on debt funds are taxable at the rate of 20% after indexation. Indexation is a method of factoring inflation from the time of purchase to the sale of units and allows inflating the purchase price of debt funds to bring down the quantum of capital gains. The longer the holding period, the higher are the benefits of indexation. Overall, indexation helps you to save tax on gains from debt mutual funds and enhance your earnings. Short-term capital gains from debt funds are, however, taxed at the income tax rate.

Conclusion

The economic slowdown and the worsening credit risks translated into fear of defaults. Investors are now more concerned about the credit evaluation of debt funds that have good credit ratings such as ‘AAA’ papers or Sovereign bonds. The long duration funds are extremely sensitive to interest rate movements. RBI policy rate cuts impact long term debt funds returns. So, it is good to choose short duration debt funds. Debt funds help to maintain stability in the time of market volatility. Before starting any investment in a debt fund, it is advisable for investors to consult with their financial advisor.