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(Precious) Words of Wisdom : "Risk comes from not knowing what you’re doing." ~ Warren Buffett

Should You Stop Investing In The Debt Mutual Funds?

Well, the straight and simple answer is NO.

An unnecessary scare is being created in the media around the safety of debt funds.

In recent times, there have been some 'minor' problems with a 'few' of the debt funds. This has been blown out of proportions. So much so that investors are getting excessively worried.

And, I am afraid that in this anxiety, they may switch their money from Debt Funds to Fixed Deposits and Post Office Small Savings Schemes.

This would indeed be a disaster — mainly for the investors. Why? Read Fixed Deposit Or Debt Fund Or PF Or Tax-free Bond Or...

Let's take a complete overview of the situation... and see why I am still in favour of the debt funds.

Before I begin, let me tell you that I have NO commercial interest in advising people to invest in mutual funds.

I have no relationship whatsoever with any mutual fund company. I earn no commission at all by selling mutual funds. I am a fee-based advisor. So, for me, it is immaterial whether I advise people to invest in fixed deposits or mutual funds. There is simply no conflict of interest.

In other words, this is a completely unbiased and honest analysis. This is no fake news and views!

debt-mutual-funds
Can you continue to trust your money with the debt funds?

First, as highlighted earlier, the recent problems (and also those in the past) with debt funds have been both 'minor' and 'limited'.

'Minor' because the investors may probably not make any returns. Or in the worst case scenario, face some erosion in their capital. They would, in all probability, get back near about the amount invested with only a small haircut.

'Limited' because the problem is only in few schemes out of the thousands of such schemes. It isn't as widespread a problem that the entire debt schemes space becomes untouchable.

That's why I stated earlier that the issue is being blown out of proportions. (By the way, I am talking about all types of debt funds and not just the FMPs or Fixed Maturity Plans which are of late making headlines.)

Yes, the risk is genuine. No one is denying that. But it is also not so big a risk that you completely give up on investing in debt funds. If a person has a diversified portfolio of debt mutual funds, the impact of such stray instances on the total portfolio will be insignificant. Whereas the overall gains will be far (far) superior. 

As I have repeatedly advocated, a good and successful investor is the one who believes in risk 'management', not risk 'avoidance'. You have to know how to manage the credit risk. You have to know how to manage the interest rate risk. [Read: How To Select The Low-Risk High-Yield Debt Funds]

Second, the long term track record of debt mutual funds over the last 25+ years has been exemplary.

Not only have these funds delivered superior returns vis-a-vis the other options (viz. fixed deposits and post office schemes) and investors have taken home far higher amounts from practically all debt schemes till date... and will continue to do so in the future too.

But also there has been NO scheme ever in which investors have lost their ENTIRE capital.

Debt mutual fund schemes invest the total corpus in a diversified portfolio comprising highly rated Govt. Securities, Debentures, Certificate of Deposits, Bonds, Commercial Paper, etc. issued by investment-worthy Banks, Govt., Public Sector Enterprises, and Pvt. Companies. It is practically impossible for all of them to simultaneously default. So it is practically impossible to lose your entire capital in a debt fund.

Whereas lakhs of investors have lost their entire investment in fixed deposits, particularly those with co-operative banks and private companies. 100% safety of the fixed deposits is a myth! [Read: Lost Capital In Fixed Deposits: Many. In Debt Funds: None.]

So, in terms of risk, you can't have anything 'safer' than the diversification offered by the debt funds.

In fact, for a few extra percentage returns, people often invest in dubious schemes and then end up losing their entire capital. As compared to these, debt funds are a far more prudent investment choice.

Therefore, it would indeed be foolish to lose faith in debt funds just because of some rare instances of marginal erosion in the capital.

Third, debt mutual funds enjoy lower taxation when the holding period exceeds 3 years (i.e. long term capital gains). While the interest income on fixed deposits is fully taxable, the long term capital gains are taxed @20% with indexation benefit. This makes debt funds far more tax efficient than the fixed deposits for investors in the higher tax brackets. [Read: 57% Tax Cut On Debt Mutual Funds Vs Fixed Deposits]

It makes no sense to give up on such massive tax savings.

Meanwhile, up to 3 years of holding period, both short term capital gains from debt funds and interest income on fixed deposit are at par and taxable as per your slab rate. So even for the shorter holding period, you are not at any disadvantage.

All said and done:

Of course, you can have 100% safety of fixed deposits with PSU Banks or the Post Office Small Savings Schemes. But then...
... you have to compromise by way of lower returns
... you have to compromise by way of higher taxes.

Or, you have the option of say 98-99% safe debt mutual funds where...
... you can expect to earn 1-3% higher returns and
... you will have to pay far lower, sometimes even nil, taxes.

So which is a better alternative?

Think!

Don't let the scary headlines everyday scare you!

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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