Should you look at debt funds to tackle market volatility?

Debt funds can add a bit of stability to your investment portfolio. It can also help reduce the risks that come with stock market investments

Kavya Balaji   /   October 23, 2020
debt funds to tackle market volatility

The markets have been really volatile this month. Even though news is that China’s economy has started to recover, the coronavirus is still rocking the world. 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.

The right asset allocation helps

Asset allocation can help you tackle market volatility. The right asset allocation ensures that your portfolio has liquidity and that your portfolio risk is minimised. It provides stability to your portfolio too.

For instance, let’s say you have 100% of your investments in equity, if the markets fall by 50%, your investments might fall by that much or even more. However, if you have 50% of your investments in equity and 50% in debt and the stock markets fall, only one half of your portfolio is affected. What about the time when the markets go up? Let’s say you have 70% in equities and 30% in debt. When the markets move up, your equity portion of the portfolio will be much higher. You can book profits and invest them in debt funds. This way, you gain and also lower your portfolio risks.

So, from an asset allocation perspective, debt mutual funds can help you minimize the volatility that’s caused by the stock markets. Debt funds can help you maintain a diversified investment portfolio too. You should pick your investment options based on your financial goal and the investment horizon.

Minimize risks

The main investment objective when you choose debt funds should be income from investments and risk limitation. Investing in highly risky debt funds should be avoided. As you know, debt mutual funds are mutual fund schemes that invest in fixed income and money market securities such as treasury bills, certificates of deposits, non-convertible debentures, commercial papers, Government securities (G-Secs) etc. Since these securities pay a fixed interest rate, the risk of these investments is much lower than equity.

Lesser volatility

Even statistics show that debt funds are much less volatile than equity funds. 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 equity funds, the average standard deviation of large cap equity funds is more than 14%. What about multi-cap equity funds? It is more than 15%. 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 the much-needed stability to your investment portfolio.

Tax benefits

When you hold debt mutual funds for a period of three years or more, they are much more tax friendly. This is when compared to traditional fixed income options such as bank deposits and small savings schemes. The interest from your bank deposit interest is taxed as per your income tax rate irrespective of the period for which you hold it. However, the capital gains from long term debt funds (held for more than three years) are taxed at 20%. You get the indexation benefits too. Indexation benefits will reduce your tax obligation substantially.

What about returns?

There might be investors who feel that their money is better off in fixed deposits and savings accounts. However, it should be noted that government securities provide better returns than bank deposits and savings account interest. At present, the 10-year Government Bond yield is at 5.93% (even after falling from the highs over the last couple of months). This is much more than 3% and 5% provided by bank savings account and fixed deposits. You can lock in the high yields of government securities by investing in debt mutual funds.

What’s happening in the debt market?

Until now, the economic slowdown and the worsening credit risks translated into fear of defaults. Investors flew to the safety of debt funds that invested in ‘AAA’ rated securities and government bonds. While all this was happening, the easing of policy rates and tools such as ‘Operation Twist’ by the Reserve Bank of India helped soften yields. This meant gains for debt funds as prices of fixed income securities went up in response to falling interest rates. Now, the yield curve is flattening and investors are waiting for an uptrend in interest rates. However, this may not happen that quickly. So, it is good to choose short duration debt funds.

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