Are Loan Funds Like FDs

While the RBI cut rates two years ago to counter the economic impact of the pandemic, banks were quick to pass the rate cuts on to FD investors. The FD’s low rate regime that has persisted for a good two years has sparked the interest of many retail investors in debt funds. Unfortunately, many investors jumped into loan funds, assuming they looked like fixed deposits, only to be disappointed later (the 2-year average return of the dynamic bond fund category is barely 1.17% so far If you are considering loan funds, here are a few things you should note first.

The issue of risk versus reward

Traditionally, most debt funds have outperformed fixed deposits over the long term. However, it is essential to understand that there are actually many types of debt funds available, each of which has a unique risk profile. For example, GILT funds, generally perceived as risk-free due to the fact that they invest only in government securities, actually have the highest degree of “interest rate risk”, or the risk of price volatility that arises from fluctuations in the underlying interest rates. . When interest rates in the economy fall, these GILT funds will strongly outperform – however, if interest rates were to rise (as they are now), they could even give you a negative return! Similarly, some funds aim to achieve higher returns by investing in bonds with lower ratings and higher coupons or yields. While these bets can pay off big, resulting in double-digit returns, sometimes they can also backfire. The severe liquidity constraints that many debt funds have faced during the pandemic are a prime example.

How they differ from FDs

Debt funds differ from FDs in many ways. First, they don’t give you a fixed rate of return. Unlike Bank FDs, which lock in your interest at a fixed rate (assuming your bank doesn’t become insolvent!), the value of your fund can fluctuate in debt funds, depending on market dynamics. Additionally, while FDs provide returns only in the form of interest payments, debt funds derive returns from the interest payments (coupons) of their underlying bonds, as well as capital gains that could occur if bond prices rise. Bond prices could rise when underlying interest rates fall or if they are raised by a leading credit rating agency like CRISIL or ICRA. Additionally, debt funds offer better exit options, allowing you to partially liquidate your money should the need arise. FDs can only be “broken” in full, usually resulting in a penalty in the form of a reduced interest rate.

Should you opt for FDs or debt funds?

Now that you understand that loan funds are not “just like FDs”, you are in a better position to make an informed decision about them. FDs are less risky than debt funds and less tax efficient. Therefore, they generally offer slightly lower returns than debt funds. Your choice should depend on your individual risk tolerance level. If you are investing in debt funds for the first time, choose those that have lower average maturities and higher credit profiles, and therefore carry lower risk. Consult a professional financial advisor to understand which debt fund best suits your risk profile and investment goals.

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