Debt mutual funds invest a significant proportion of your money in government securities, debentures, corporate bonds, and other money-market instruments that are relatively low-risk. These funds play a vital role in the portfolio by providing stability and diversification anchored on sustainability and risk management against market volatility while ensuring a modest income.

Just as equity funds are important for growth, debt funds provide the cushion to absorb the shocks from a volatile market in the portfolio. Debt funds produce steady returns, ensuring that when growth equity assets underperform in a volatile market, you don’t draw a blank on the performance score. Given their crucial role, retirement planners can’t ignore debt instruments if they want an effective strategy to deliver their goals.

Here are some advantages and disadvantages of debt funds:

Benefits

Diversification: Keeping all your eggs in one basket is fraught with risks in case something adverse were to happen to your holdings. Diversifying the portfolio into debt, equity, etc., will effectively distribute the risk and minimise the threat of losing everything in a single event.

Also Read: What Are Retirement-Focused Mutual Funds? Check the Performance Of Top Three Funds

Risk Management: Addressing risk is a vital part of portfolio management. Depending on your risk appetite, you can increase or decrease your debt holdings vis-a-vis the equity assets that are relatively more volatile. Your age and income potential also influence your risk-taking ability. However, if you start saving for retirement early, you can avoid or considerably reduce the risks by aligning your available financial resources according to the market conditions. Conversely, if you start late, you cannot take advantage of time in your favour, exposing you to higher risk if you invest aggressively to minimise the gap in your retirement corpus.

Stable Returns: Debt funds usually provide stable returns, averaging around 6-7 per cent annually. This is because the government securities where they invest are low-risk instruments and provide guaranteed returns. Investment in other debt assets is also relatively manageable as you can research them for performance and other aspects before investing.

Also Read: Mutual Fund Ratings Shouldn’t Be A Buying Factor; Boost Debt Assets For Income, Protection

Risks

Credit Risk: Debt funds loan your money to a public or private corporation. Lending money always carries the risk of repayment failures. For instance, for whatever reason, if a corporation fails to return the money to the fund, you may suffer losses, although such incidents are rare.

Interest Rate Risk: Debt funds may suffer interest risk due to a negative correlation between the bond price and the interest rate. If the interest rate goes up, the prices will fall and vice-versa. However, the degree of risk varies from one bond to another. Therefore, those with shorter maturity periods may face less risk than those with a longer maturity bond.

Liquidity Risk: This may happen when there is a surge in redemption requests, making it difficult for the corporation to return the money to every investor all at once. This situation can cause a liquidity strain in the company, leading to dissatisfactory returns for the investors. Effective management of liquidity risk on the part of the corporation is highly required to avoid such situations.