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Are debt mutual funds safer than equity mutual funds?

By Finserv MARKETS - Aug 26,2019
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Are debt mutual funds safer than equity mutual funds

Introduction

Mutual funds are an investment device whereby money in the form of investment is pooled from a number of investors who share a common financial goal. This pool is maintained by a fund manager – this involves investing the sum from the pool into various instruments like company stocks, shares and bonds, in accordance with the risk appetite of the investors. The risk profile of the investors is the governing parameter for the kind of portfolio the fund manager builds. Since mutual funds pool capital from different investors, it reduces the overall risk of investment and then the pool goes into different investment destinations. Your goal, investment horizon, and risk profile would determine the choice of your schemes, which are divided broadly as equity mutual funds, debt or hybrid mutual funds.

Equity Mutual Funds

Equity mutual funds that invest at least 65% of their funds into equity shares. Classified as large cap, small cap, mid cap, sector-based stocks. Equity mutual funds are risky because their movement and growth are dependent on stock market performance. But the risk can potentially pay off well, with the dividend getting reinvested for goals of growth.

Debt Funds

Debt mutual funds invest in a range of fixed income instruments, like money market instruments, government securities, rated bonds, corporate bonds and debentures, commercial papers, treasury bills, and fixed income securities varying across their maturity periods.

These have assured returns and are opted by investors with low-risk profile and those who prefer ready liquidity.

Hybrid Funds

As the name suggests, these mutual funds invest in a mix of debt and equity. In accordance with the investors’ risk profile, an aggressive hybrid fund will invest majorly in a bouquet of equities, and a conservative version will invest the majority in debt instruments.

Now, let us understand the level of risk exposure these funds face:

You often hear in mutual funds advertisements that mutual funds investments are subject to market risk. What it doesn’t tell you is that not all risks impact all the fund schemes. The Scheme Information Document (SID) helps you understand which risks apply to your selected scheme. This risk – both the magnitude and type of risk – is determined by the nature of funds that a particular mutual fund scheme invests in. Certain securities are more sensitive to certain risks and some are exposed to some other. Equity mutual funds and debt funds are exposed to different types of risks – credit risk, interest rate risk, liquidity risk, market/price risk, business risk, event risk, regulatory risk, etc. Usually, equity mutual funds are exposed to higher market risks because they also come with the possibility of higher returns. But remember that higher returns come to those who invest in equity after careful study and adopting a patient, long term time horizon. In fact, risk in equity can be mitigated by adopting diversification as well having a longer term time horizon.

On the other hand, we have debt funds that invest your money in interest-bearing securities like bonds and money market instruments. These securities promise to make regular interest payments to these funds.

The risks around debt mutual funds are as follows:

Firstly, since these funds invest in interest-bearing securities, their Net Asset Values fluctuate with changing interest rates. Prices of these funds fall when interest rates rise and vice-versa. This is called the interest rate risk. Secondly, these funds are subject to credit risk i.e. the risk of not receiving regular payments from the underlying securities (e.g. bonds) they have invested in. Therefore, just because debt funds come with assured returns does not necessarily mean that they are safer than equity funds. Both the funds have a different suitability with debt funds being more suitable for short-term financial goals.

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