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Debt vs. Equity funds: What’s the real difference?

Birla Sunlife - Grow My Money - Debt vs. Equity funds: What's the real difference?

For far too long, new mutual fund investors have grappled with the question of where s/he should invest in, should it be equity funds and debt. There is much confusion and debate as to which might be a better investment. To be fair, much of this is quite unnecessary as debt and equity can be differentiated based on asset allocation, financial interest, risk profile, how they are traded and how they make profits for the investor. While both types of funds seek to deliver potential returns, understanding the difference between them will help an investor decide on his/her asset allocation.  So let’s begin with calling out the difference between the two:

Nature of the fund

The most striking difference between the two is in the way the funds invest money. Debt funds pool money raised from people and invest it in fixed income instruments like government bonds, corporate bonds, non-convertible debentures and other highly-rated instruments.

Equity funds deploy money raised from investors into equity and equity-linked instruments. If a fund invests more than 65% of their portfolio in stocks, they are generally considered as equity funds.

Risk factor 

Equity funds are inherently considered to be riskier as compared to debt funds. As equity funds invest in stocks, any change in share prices will have a corresponding impact on the Net Asset Value (NAV) of the fund. Stock prices are sensitive to economic factors like inflation, currency fluctuations, tax rates and central bank policies etc.  Hence equity securities by nature are volatile.

However, a good equity mutual fund scheme will invest their corpus in multiple companies or industries providing diversification which makes it less volatile as compared to equity markets.

Debt funds primarily invest in rated bonds and in which defaults are rare. Government bonds are considered virtually risk-free. Corporate bonds are rated by different credit rating agencies which allow the investor to gauge the risk of the investment. As long as the bond issuer makes interest payments and the maturity value of the bond, there shouldn’t be any problem.

However, it is important to remember that bond prices are sensitive to interest rate changes. Hence debt funds investing in bonds will also see a corresponding fluctuation in the NAV of the fund. While debt funds are considered safer than equity funds, it would be a misnomer to classify them as risk-free.

Tax Liabilities

Mutual funds are taxed differently depending on the type of fund and duration for which the fund is held. Equity funds held longer for 12 months are considered “long-term” and are exempt from capital gains tax. Equity funds held for 12 months or less are considered “short-term” are taxed at a flat rate of 15%.

Long term capital gains tax is applicable on debt funds held for more than 36 months. The tax rate for long-term debt funds is 20% with indexation (adjusted for inflation). For short- term mutual funds, the capital gains is added to the investor’s income and then taxed according to the slab they fall under.

Returns 

Since equity mutual funds invest in shares of companies, they generally give potential returns over the long run as compared to debt funds. However, since equity funds are also volatile, there is also a possibility of losses and negative returns.

Meanwhile, the returns from debt funds are considered to be steady and in a constant range. Since these funds invest money in treasury bonds, there’s much less risk associated with them.

Typically, in volatile times and when the future prognosis is gloomy, debt funds are generally considered as a good investment. But when times are good, and markets are booming, equity funds are a feasible source to seek returns.

Source: AMFI

In the end, picking a fund should be based on the investor’s risk appetite, financial goals, time horizon and most importantly research. In fact, there should not be an either/or between debt and equity funds, but rather an ‘and’. That means debt and equity both should be a part of an investor portfolio. Taking the cricketing analogy, sometimes you need an attacking batsman in your team and at times, you need a defensive batsman. But you need both in your team. An investor may consult his financial advisor before investing in the schemes of mutual funds. Similarly, you need both debt and equity in your portfolio. So, there should not really be confusion on the same. Happy investing!

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