An oft-asked question when investing in mutual funds often starts and ends with concerns over the safety of capital. The answer to that is simple – theoretically, there is no such thing as a guarantee of perfect safety in any kind of mutual fund, both equity and debt. The rules of the game are such that mutual funds cannot operate in India by guaranteeing returns or safety of capital. However, when selected carefully, chances of capital erosion is unlikely when it comes to investments in debt funds. Yet, there could be an extreme possibility of small losses and are temporary.
Typically, a debt fund invests in bonds. Bond prices generally rise or fall in response to interest rate changes, or like any market, the expectation of interest rate changes. And, the best way to avoid losses in bond funds is to match your period of investments with what is called the 'maturity' of the bond fund. Moreover, as long as the bond issuer pays the interest and redeems the bonds when they are due, there should be no losses. Since practically all bond investments by Indian funds is in highly-rated instruments and defaults are rare.
What could go wrong?
Bonds are tradable instruments that are bought and sold in a bond market just like stocks are in the stock market. So, there is possibility of the price of bonds to go down and up and result in the fluctuation of the NAV of debt funds. For instance, when the price of a bond goes down, then the NAVs of debt funds holding those bonds will fall. If investors in that fund sell at that point, then they could face losses.
Bond prices generally rise or fall in response to interest rate changes, or also respond based on expected change in interest rates. A way out to check the loss when investing in bond funds is to match your period of investments with what is called the 'maturity' of the bond fund. The maturity refers to the period after which the bonds held by a bond fund will mature.
If you are investing for a short period like a few days, then go for liquid. For longer periods of investments, the suitable fund categories are short-term funds and then the medium and longer term categories. If the period of investments is fixed and you don't think you have the money on call, then Fixed Maturity Funds (FMPs) are best. This kind of a systematic approach, along with good fund selection, will ensure that the chance of making a loss in debt fund investments is minimised.