Where to invest money: Equity funds or debt funds, here is all you need to know in brief

Financial planners generally recommend a higher allocation to equity fund for an investor with higher risk tolerance and a longer investment horizon. Similarly, they recommend a higher allocation to debt funds for a person with lower risk tolerance or a shorter investment horizon.

Proper asset allocation is key to optimum return, minimizing volatility and maximizing return. Image source: Pixabay

It is quite common that people ask questions about where they should invest, in equity funds or debt funds and the timing of such investments. The frequency of such questions increases, especially when either the markets have risen phenomenally or when the markets have fallen sharply. Generally, investors remain overweight or underweight on a particular asset class, be it equity, debt or reality depending on their recent performance. However, choosing between asset classes is not about which segment has given highest or lowest return in the recent past. It’s all about asset allocation, which is a function of risk tolerance and investment horizon. Proper asset allocation is key to optimum return, minimizing volatility and maximizing return.

Financial planners generally recommend a higher allocation to equity fund for an investor with higher risk tolerance and a longer investment horizon. Similarly, they recommend a higher allocation to debt funds for a person with lower risk tolerance or a shorter investment horizon. Within the particular asset class too, the allocation of various types of equity funds or debt funds, in turn, depends on risk tolerance, return expectation and the investment horizon. It is in this background, we look at the debt part of the overall asset allocation, and where they should look to invest given their risk appetite and investment horizon.

Why Fixed Income Yields Corrected?

Debt market has been in the bear grip in the last six months, with yields rising over 125 basis points (bps) on the back of adverse macro developments both on the domestic as well as on the global front. Domestically, consumer price index (CPI) inflation has breached the 5% mark, driven mainly by higher food, fuel and housing prices. The market also expects the inflationary pressure could revisit the economy due to shift in government policies from supporting consumers to supporting food producers, which will increase the MSP prices. Oil prices are on the upswing, above 65$ a barrel and expected to remain high due to global growth inching upwards. Global bonds yields too are on normalisation mode, with the US and Eurozone the yields rising and QE ending. Significant reduction or reversal in capital flows may put pressure on the rupee.

So which mutual fund (MF) category should fixed income investors invest depending on risk appetite?

Liquid Fund is the type of MF’s that invest in securities with residual maturity up to 91 days. Investment is made in short-term money market Securities. The money that we keep in savings bank can be invested in liquid funds.

Liquid Plus Funds are known as an ultra short-term category and can invest in securities with the maturity greater than 91 days. (91-365 days). This type of fund protects against interest rate risk, but they are not immune to market fluctuations. Investors having three to six months idle money can park funds in this category.

In the short-term fund, money is invested typically in assets with an average maturity of one-three years. Type of assets includes a corporate bond, government securities and state development loan and money market instruments. At the end of three years, the investor gets indexation benefit which might help in reducing the burden of taxation. On similar lines, there are fixed maturity plans which have a lock-in period of around three years. Here the returns are not guaranteed. But past track record shows that FMPs with at least 80% AAA papers have delivered decent returns.

Credit Fund is generally for an investor who has a high-risk appetite and expects higher returns. Generally, in case of short-term and bond fund category, money is invested in higher-rated instruments. However, in credit fund, a large part of the portfolio is invested a the lower rated instrument. (Below AAA rating). While investing in such funds one must check scheme’s liquidity, diversification across different sectors, top 10 holdings, YTM etc. Upgrade in any security rating increases the fund performance and adds to mark to market gains.

In Bond Fund, money is invested in bonds with average maturity of around more than five years. Type of assets includes a corporate bond, government securities and state development loans. Whenever MF buys securities they are giving a loan to the government, corporates or states to fulfil their requirement, in return for this MF’s will receive fixed coupon payment and principal amount on maturity. The credit rating of the issuer reflects their ability to repay principal and interest payment, therefore Higher credit rating reflects lower interest rate.

Note- Conservative investor should choose a bond fund with higher credit rating. These categories of funds are for investors having long-term investment horizon.

Government Securities Fund

Investors who do not want credit risk, but want to have duration risk invest in such type funds. Type of Assets includes Government Securities with various maturities. These types of funds do well when the interest rates decline. In a rising interest rate scenario, they can prove fatal. Again investors who have the required knowledge or are being advised by the distributor can block their money for long in this category.

Investors can choose from scheme category mentioned above depending on their risk appetite or take advice from professionals before investing.

ENSURING RETURNS

Generally, investors remain overweight or underweight on a particular asset class, be it equity, debt or reality depending on their recent performance
Financial planners generally recommend a higher allocation to equity fund for an investor with higher risk tolerance and a longer investment horizon

By Marzaban Irani, fund manager, Debt of LIC Mutual Fund

Source: DNA Money

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