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SIP in Debt funds: Is it a good idea?

SIP or systematic investment plan which refers to investing a predefined amount periodically in mutual funds has become synonymous with investing in equity mutual funds. This is because investing in equity mutual funds through SIP helps tide over the volatility prevalent in equities and also allows you to benefit from the power of compounding and rupee cost averaging over the long term. However, in the case of debt funds, SIPs were roughly less than 5%[i] of the total funds invested via SIP in FY20.

It must be noted that although the equity market is much more volatile than the debt market, the concept of timing applies to debt funds as well. Debt mutual funds invest in fixed income instruments such as bonds, government securities, and T-bills, whose price movements are sensitive to change in interest rates. Therefore, interest rate fluctuations can work for or against you when you are invested in debt funds. For example, if you invest in a debt fund and interest rates rise, the value of your investments declines, and vice versa. Thus, investing via SIP route can help in reducing the risk arising out of change in interest rate in the market.

Investing in debt funds through SIPs can be more beneficial to those looking to invest in a long-tenure fund. Medium- and long-term debt funds are riskier than short-term debt funds given that a longer tenure implies a larger impact of change in interest rates on your debt fund portfolio. SIP in debt funds can not only help sail through such interest rate volatility but also allow investors to invest a small amount regularly.

Debt Fund SIPs, thus, help cultivate the habit of regular savings and investments as in the case of traditional instruments such as recurring deposits or RDs. However, SIP in debt mutual fund has several benefits over RDs.

First, RD returns are taxed at your personal income tax rate. This can be as high as 30%. On the other hand, with debt mutual funds, you get the benefit of indexation in case of long-term capital gains (LTCG) taxation structure (if the holding period exceeds 3 years). LTCG in the case of debt funds is taxed at 20% post indexation. Indexation is the concept of recalculating the purchase price post adjustment for inflation. Thus, after the purchase price is adjusted for inflation, the capital gain comes down. Second, debt fund SIPs offer more liquidity compared to RDs, as the latter may penalize you on premature withdrawal.

Debt funds are ideal for investors whose risk appetite is relatively low. Debt funds are also suitable for those who cannot commit to equity funds for the long term in the backdrop of income uncertainty. Further, SIP investment in different debt funds can serve specific needs. For example, SIP in short term debt funds can help build a corpus towards near-term goals such as financing a vacation or a vehicle purchase.

While equity mutual funds are a preferred investment avenue for a long-term investment horizon, debt funds also play an important role in diversifying your portfolio. With diversification, debt funds help in balancing the overall risk of the portfolio. This makes debt funds a crucial part of the portfolio mix. An SIP in debt funds will help you achieve diversification and investment discipline along with helping in ironing out the impact of interest rate volatility.

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