Risk Factor: Debt Funds vs Equity Funds

Risk Factor: Debt Funds vs Equity Funds
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Planning to invest in a mutual fund? Your financial advisor is likely to advise you to invest in either debt or equity funds depending on the level of risk you’re willing to take and the period of time you’re willing to wait.

Mutual funds, broadly, can be categorised into 2 – Equity Funds and Debt Funds. The below table distinguishes between the two types of mutual funds.

Equity Funds Debt Funds
Invests in Atleast 65% of the corpus is invested into the stock market Majority of the corpus is invested in fixed income securities
Purchases Stocks and shares and related securities Bonds, corporate deposits, debentures, government securities, etc.
Taxes Short term capital gains (not more than 12 months) are taxed at a rate of 15%. Long term capital gains are exempt from taxes. Short term capital gains are taxed as per income tax slab and Long Term Capital Gains are taxed at the rate of 20% with indexation
Risk and Returns High Risk, High Returns Low Risk, Low Returns
Suited for Investors looking for long   term investments Investors looking for short to mid-term investments

Both categories of funds are subject to market risks. Debts funds are a relatively low-risk, but they are certainly not risk-free. Let’s look at the various types of risks in a debt fund and how you can identify them.

A type of risk that is market-linked and is defined by the maturity profile of the bond is the interest rate risk. This risk is measured by duration, which is a measure of how bond prices react to changes in interest rates. Longer the tenure or further the maturity of a bond, higher is the interest rate risk.

Credit risk refers to the credit worth of the issuer of the debt fund. It takes into account whether the bond issuer is able to make timely interest payments and also the face value at the time of maturity of the bond.

If the issuer is unable to do so, it brings down their credit rating and the bond is said to be in default. Chances of a default are higher during an economic downturn.

Liquidity in a debt fund refers to the ease with which a fund manager can sell a particular security in the market. A fund faces liquidity risk if the fund manager is not able to do so due to lack of demand for the security.

Equity funds are known for their high risk, high returns game. Let’s understand the type of risks faced by equity funds.

Markets and economies play a crucial role in the performance of equity funds. The price of a company’s shares can be affected by inflation, interest rates, current and capital account deficit etc.

Not just the economy or the market, but a fund can also face industry risk. The industry in which the company operates also affects performance which indirectly leads to fluctuation in share prices.

Equity funds might not be limited to domestic markets and may operate internationally- a practice that exposes them to currency risk which in turn affects the share prices.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.

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