Why do we need debt funds? Is PPF, EPF and SSY not enough?

A reader asks, “I’m unable to understand the need to venture into debt funds for my needs. What are the advantages they offer on the alternatives for the long term – PPF, EPF, SSY etc.? I’m primarily saving for retirement, and currently, almost all of my debt part is into epf and ppf (about 50% of my portfolio), nothing in FDs (except emergency cash).”

Before we consider the specific question, some general remarks may be in order. There are several goals for which PPF, SSY or EPF cannot be used. For example, a need seven years away.

For such situations, a traditional fixed income instrument like an FD or RD can certainly be used but will not be tax efficient for two reasons: (1) They will be taxed as per slab. For those in the 20% or 30% slabs, this is not efficient compared to a debt mutual fund which is taxed at 20% with indexation (this will lower the effective tax rate as per inflation)

(2) The tax to be paid each financial year in the case of RDs and FDs. In the case of mutual funds, tax is applicable only upon redemption. Longer the investment period, the higher the benefits of debt mutual funds. See: Debt Mutual Funds vs Fixed Deposits Calculator.

This advantage comes with a price. The returns from debt mutual funds are uncertain, but it is possible to choose a reasonably “safe” debt fund suitable for our needs using some simple ideas. See: How to start investing in debt mutual funds – a primer.

Now let us consider the specific question asked. Yes, it is okay to have only 50% EPF+ PPF and 50% equity (assuming this is where the reader is invested) for a retirement goal for a start.

However, the portfolio will soon have to be rebalanced. If the value is small, then the entire amount redeemed from equity can be shifted to EPF (VPF) or PPF. Once the portfolio grows in size, another fixed income instrument becomes essential.

A debt fund is the obvious, tax-efficient candidate here. One cannot lock up significant chunks of the portfolio in EPF, which cannot be redeemed at will. PPF, thankfully(!) has an Rs. 1.5 lakh investment limit.

Also, debt allows for two-way rebalancing. That is, from equity to debt and debt to equity. Moreover, when the portfolio is de-risked systematically, the equity portion will need to be shifted to fixed income, for which debt funds are the obvious choice.

I have followed this strategy – gradually adding debt funds – for both retirement and my son’s future portfolio. See: Why I partially switched from ICICI Multi-Asset Fund to ICICI Gilt Fund and Why I started to invest in Parag Parikh Conservative Hybrid Fund.

When we say “start accumulating a corpus for retirement”, we assume that the corpus will only be withdrawn at the time of retirement. When we say, “hold 6-12 months’ worth of expenses in safe instruments like FDs for emergencies”, we assume our emergencies will never cost more than that.

Having a net worth of several lakhs or crores is naturally welcome, but how much of that is “liquid” matters. That is, how much of our net worth can we liquidate to handle emergencies that stretch beyond the “usual” makes a difference.

Liquidity – the ability to freely invest or redeem at will – is an essential part of portfolio management. Equity investments (with the exception of ELSS mutual funds) are liquid. Investments like EPF, PPF, SSY and NPS (which is a mutual fund) only have limited liquidity. Going overboard on such fixed income options, especially with small equity exposure, can hamper our ability to handle the vicissitudes of life.

In summary, debt mutual funds are liquid, tax-efficient choices for long-term goals and are essential to reduce the risk in portfolios as they grow bigger. There is no need to be scared of debt funds. It is possible to choose a reasonably “safe” debt fund suitable for our needs using some simple ideas.