Should Debt Investments be part of your Long Term Portfolio?
Today, most investors understand that for longer duration investment, equity is the best option. But what they may not realise is that unlike fixed income instruments, equity never grows in a linear fashion. It goes through a lot of ups and downs over time. While seasoned investors take these fluctuations in their stride, an investor who is relatively new to stocks could become anxious. Including debt in their portfolio along with the equity could help ease the stress for such investors, even if the investment is for a longer period. Let us see why one needs to allocate a certain portion of investments to debt even for the long term.
1. Debt brings stability to a Portfolio
Many investors tend to get attracted by the past return of equity without assessing their own risk appetite. But once reality dawns on them that equity returns are volatile and can deliver negative returns too, they get petrified and tend to exit at a loss. So, for such investors, it is always imperative to know their risk profile first and allocate their funds accordingly. Including debt in a portfolio will not only provide stability but will also protect them from taking impulsive decisions like selling equity or equity funds at a loss. In the table below, we have presented benchmark past returns and volatility for portfolios with different combinations of equity and debt.
Data is between 2003-2020
Source: SBI MF
What clearly emerges is that over the long term, as the proportion of equity increases in the portfolio, so do the returns. However, it comes at the cost of greater risk (higher standard deviation implies more volatility in the portfolio, which could give an investor some stress).
2. Debt can work as emergency funds when markets are at low
In the month of March, 2020, when the entire market crashed because of the ongoing pandemic, the equity segment fell by around 40%. And during that same period, many people lost their jobs. During such a situation, if any emergency had arisen, which necessitated encashing investments, investors with 100% of their portfolio in equity would have incurred huge losses. The availability of debt in a portfolio, which can be encashed at a predictable value, allows an investor to avoid losses that could occur from aggressively selling equity.
3. Sometimes Debt outperforms Equity
As equity tends to be more volatile than debt, there are times when debt has outperformed equity. In the table below, we have considered equity mutual funds and debt mutual fund, showing the performance of various categories since the last 10 years. These are yearly returns and are intended to demonstrate volatility.
The above table depicts that in 2011, equity delivered negative returns; then again, 2015 and 2016 were low return periods for equity. Whereas 2014 and 2017 were excellent years for equity. It can be observed that because of the volatility associated with equity, there are times when equity funds have given lower returns than debt funds. So, those investors who cannot digest such volatility should include debt funds in their portfolio along with equity funds.
Are Fixed Deposits a better option than Debt Funds for Long term allocation?
Fixed Deposits have been the favourite investment instrument of most Indians. Investors may think that as they have Fixed Deposits in their portfolio, they may not need to invest in Debt Funds as well. But there are some points that every investor needs to consider since Debt Funds can be a better option than regular Fixed Deposit investments.
1. Reinvestment risk:
Around 20 years back, Fixed Deposits were returning approximately 10% p.a. But today fixed deposit rates have come down to merely around 5% p.a. Most Fixed Deposit investors invest for 3 to 5 years and renew their investments when these mature. So, when investors renew Fixed Deposits, they tend to reinvest at a lower interest rate. Also, the current interest rates applicable on Fixed Deposits are lower than the current inflation rate, which means the real rate on these instruments will be negative.
2. Liquidity Problem
If an emergency arises and there is need to withdraw money from a fixed deposit, then the bank charges a penalty for it. But there is no penalty for exiting debt mutual funds.
3. Taxation Benefit
With Fixed Deposits, investors have to pay tax on interest income as per their income tax slab. So, an investor who falls in the 30% tax slab, will have to pay 30% tax on the interest income earned from a Fixed Deposit. But in the case of Debt Funds, if investors redeem within 3 years, they will have to pay as per the income tax slab; those who redeem beyond 3 years will have to pay 20% along with the benefit of indexation.
How different categories of Debt Funds can be allocated for different financial needs
As there are several categories of Debt Funds, it is important that investor should know how they can allocate these debt funds for different purposes, as per their risk-taking ability.
1. Emergency: An emergency can arise at any point of time. So, investors should invest it those debt funds which are least risky and are subject to minimum volatility. While investing in these funds, returns should not be the primary goal of the investor. Overnight Funds, Liquid Funds and ultra short-term funds can be considered as investments for emergencies.
2. Long Term: While investing for the long term, investors should choose those funds that will not only bring stability to their portfolio but will also deliver more returns than fixed deposits, if possible. Investors can invest in Short Term Funds, Corporate Bond Funds and Banking & PSU Funds.
3. Tactical: These funds should only be included in a portfolio when an investor sees any opportunity for growth. For instance, if an investor feels that going ahead there will be a rate cut, then Gilt funds can be included in the portfolio. Other funds which can be used for tactical purposes are Medium Duration Funds, Long Duration Funds and Credit Risk Funds.
You may also like to read: Are you reading the Q3FY21 report card of IT companies the right way?
We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.