It is well-known that the key to generating optimal risk-adjusted returns and achieving your financial goals is to create a well-diversified investment portfolio. This can be accomplished by investing in a variety of instruments that are spread across the risk-return spectrum. Generally, equity investments are considered as vehicles of long-term wealth creation while debt investments are expected to provide steady returns and downside protection. Consequently, equities traditionally carry a higher level of risk compared to debt instruments. However, it is important to consider that debt investments are not risk-free and even within the wide spectrum of debt offerings, different instruments carry varying levels of risk.
Risks in debt investments
Debt investments have several sources of risk – key among them being credit risk, interest rate risk, and liquidity risk.
- Credit risk: This refers to the issuer risk or the risk of default. It stems from the possibility that the issuer may default on the payment obligation because of which you might not receive the full value of the principal amount invested.
- Interest rate risk: Bond prices have an inverse relationship with interest rates. Bond prices fall with a rise in interest rates and vice-versa. This means that the value of the debt investments in your portfolio will fall with a rise in interest rates. This could lend some volatility to your portfolio.
- Liquidity risk: This refers to the ease with which you can buy and sell the bonds in your portfolio.
An ideal solution
Inarguably, as an investor, you have the option to invest in a wide variety of debt instruments ranging from different categories of debt mutual funds to bonds. However, an ideal solution that can help you combat many of the above risks is a Target Maturity Debt Index Fund. This is a debt investment option that has the features of a bond, i.e., defined maturity and predictable returns, if held till maturity, and has additional features that can help you address the challenges related to liquidity and accessibility. The Target Maturity Debt Index Fund with PSU bonds and SDLs as underlying scores over other investment avenues by packing several benefits in one product. These include:
- Predictability of returns: Due to the quality issuer (PSUs) and defined maturity, the returns from the Index fund become more predictable. The issuer related risk is minimal in these funds since the investment is largely in government and PSU bonds. The interest rate risk is minimised through a target maturity structure that will bring predictability in returns if you stay invested till maturity. A defined or target maturity means that the bonds in the portfolio will mature within a fixed term.
- Easy and low-cost access: Unlike in ETFs, you do not need to transact through a demat account to buy or sell units in an index fund. You can simply buy the units through the fund house, like you would for any other mutual fund scheme.
- Liquidity: Since you can easily transact through the mutual fund house to buy and sell units in the Index fund, you need not worry about liquidity on the exchange for transacting.
- Transparency: Since debt index funds replicate an underlying debt index, they offer better liquidity and transparency in terms of investments, issuer ratings, and maturity.
- Taxation benefits: Index funds are also relatively more tax efficient than directly investing in bonds since the coupon earnings from bond investments are taxed at marginal rates. On the other hand, index funds are taxed with the benefit of indexation which can potentially reduce the tax liability on your investment returns.
As an investor, you shouldn’t have to settle for sub-optimal solutions when it comes to creating an ideal investment portfolio. Thus, if you are looking to invest in a relatively safe and value accretive product, then you should definitely consider investing in the Debt Index Fund.
Disclaimer: Ms. Radhika Gupta is the MD & CEO of Edelweiss Asset Management Limited (EAML) and the views expressed above are her own.
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