What are mutual funds
In simpler words, mutual funds are an investment pool that is managed by professionals. It is an investment fund wherein many investors pool their resources to purchase securities. They share the returns as well as the losses that the securities bear due to market fluctuations. The investors can be both retail or institutional.
Mutual funds are emerging as a commonly used instrument to raise money due to easy diversification and liquidity that it provides to the investors. Being managed by professionals it ensures the safety of the money invested, but the same time you may have to bear plenty of fees and charges.
Debt Mutual Funds
Depending on the investment strategy there can be many types of mutual funds. Your choice of a mutual fund can be dependant on your investment capacity and goals.
Debt mutual funds are invested majorly in the securities that have a fixed rate of interest. These are comparatively less risky as compared to other mutual funds. They also carry a fixed and steady income, making it an appropriate investment option for medium or long term investors. A few examples of debt mutual funds can be debentures, corporate bonds, government securities or commercial papers, along with other money market instruments. They generally bear a fixed maturity date and earns a fixed income. To be assured about the risk involved, there is also an option for the investors to check the credit rating. These ratings are accredited by independent organizations like CRISIL, CARE, and ICRA and help immensely to determine the investment decision.
Negative returns on mutual funds
Debt mutual funds are a safer investment option owing to many reasons. So, if you are still wondering if your debt instruments can earn negative returns on your investment, then you are right. It is possible for a debt mutual fund to bear returns that are negative.
A debt investment bears return to the investors in two ways; the first being interest earned on the instrument held by the person and second is the change in the price of the security held at the time. The return earned on the mutual funds can fluctuate with changes in both the above-mentioned scenarios.
However, the return touches negative side when the interest rates start rising. Sounds odd? Let us explain. When a new debt mutual fund is introduced in the market, and it bears higher interest rates, the value securities with lower interest rates fall down, hence causing negative returns on the mutual funds. Inflation can be another contributing factor to this problem. When the inflation rises, the value of money also reduces. Therefore, with the increasing inflation, the prices of the bond move up. Inflation also affects the yields on the securities.
What should an investor do
If you have already invested in these funds, experts suggest continuing investing until they reach the targets set previously. Although it increases the risk of short term capital losses, it is beneficial for the long run.
But if you are planning to invest in debt securities, you must look for the ones with a shorter maturity period and more liquidity.
Some crucial things must be considered before purchasing debt securities. It ensures the safety of investment and helps to earn regular yields. Following are the points that one must keep in mind:
The interest rate is of utmost importance when considering investment in debt mutual funds. Interest rates are volatile in nature; they go up when the economy is doing well whereas falls with a recession like situation. Bond prices also have a relationship with the interest rates, although it is inverse. With an increased rate of interest, the price of a security falls and rises with the decrease of interest rate.
The interest also deviates with the maturity period. Securities with more extended maturity period have higher interest rates whereas the more liquid ones bear a relatively lower rate of interest.
Credit rating given to any particular security determines the risk of losses involved in it. It pertains to the default by the borrower concerning payment made to the lender. These ratings are credited by independent professional bodies like CARE, CRISIL, and ICRA to the bonds determining the ability to meet debt obligations and cash flow.
A rating of AAA is given to the securities which have negligible risk involved and are of highest quality. It is always better to check the rating beforehand, to make an informed decision.
Liquidity and concentration:
Concentration is said to be the number of specific bonds held by an investor. Higher the concentration more is the risk involved. The extent of losses is naturally more when you are holding a significant proportion of a particular security and it defaults.
Liquidity too is an important thing to be considered. It has an impact on the value and interest that it yields. Along with it, the investor must also be clear about the goals and expectations. If you are looking for a short term investment option, one can go for securities with a shorter maturity period like commercial papers, where debentures are a suitable option for long term investments in debt.
Having said all that, it is clear that debt mutual funds are extremely volatile and carry a plethora of risks. It must be noted that no mutual funds assure full returns on your investment. So, it is always better to create a diverse portfolio with different securities to mitigate the risks. If you still think debt mutual funds are risky, you can look for much safer options like Public Provident Fund or other government plans, but then again they come with less liquidity and higher maturity period. To play safe, be sure about your goals, prioritize and take a sound action.