A debt fund provides diversification and stability to a mutual fund portfolio. Usually, there is an inverse correlation between debt and equity investments, so when one goes down, the other often goes up.
A portfolio that includes equity and debt provides more stable and consistent returns. Someone who invests only in equity will face much more volatility and risk.
An investor with a moderate risk tolerance can add a debt fund to the portfolio to reduce the level of risk and volatility. Proper asset allocation ensures that you will have the right levels of equity and debt. Consider your goals, age, risk tolerance, and return expectations while deciding on your asset allocation.
Of late, debt funds have been under stress due to delays and defaults in interest and principal payments from companies to which they had lent money. As a result, market regulator SEBI has tightened lending norms for the mutual fund industry. These measures will help to improve transparency and reduce the risk for investors.
There are so many categories of debt funds that investors find it hard to pick funds that are suitable for them. Here we will look at how to choose the right debt mutual fund category for your needs.Learn how to mange your money & create wealth, Download your FREE eBook now
1.Know about the different types of risk
A debt fund faces the risk of being unable to sell securities because of a lack of demand for them. The level of liquidity risk depends on how easy it is for a mutual fund to sell an instrument in the market.
Interest rate risk
Debt mutual funds face the risk of interest rate changes, which impact the prices of the securities in which they invest.
Debt funds face the risk of default by the issuers of the instruments in which they invest. A fund manager can boost returns by investing in securities with lower credit quality. However, this increases the level of risk for investors.
Rating agencies assign credit ratings which indicate the creditworthiness of the borrower. If you cannot afford to take too much risk, look for debt funds that invest mostly in AAA-rated instruments.
Also Read: Understanding Debt Funds & associated risks
2.Basic technical terms related to debt funds
Yield to Maturity
Yield to maturity is the overall return that a bond is expected to provide if held to maturity. It is considered to be a long-term bond yield but is in the form of a yearly rate.
The portfolio of a debt fund consists of many bonds with different maturity dates. The average maturity is the weighted average of the maturity of all securities in which a debt fund invests.
This formula measures the change in the value of an instrument as a result of fluctuations in the interest rate. The concept that bond prices and interest rates move in opposite directions is the basis of the formula.
3.Things to consider while choosing a debt fund
Your risk tolerance
Assess your risk tolerance and look for a debt fund that matches it. Debt funds invest in different types of instruments, ranging from the safest government securities to risky corporate bonds.
Your investment period
Think about the period for which you are investing and look for a debt fund with a similar maturity profile.
Keep track of interest rate trends
When interest rates are declining, consider investing in longer duration debt funds. When interest rates are rising, it may be best to move your money to short-term debt funds.
4.Determine which fund category suits you
These mutual funds invest in short-term securities with a maturity of up to 91 days. The level of risk is low, and they suit investors who want to park surplus funds for short periods and want to earn more than what bank deposits can pay. Recent changes in SEBI rules will ensure that the Net Asset Value (NAV) of liquid funds will be more realistic.
Ultra short-term funds
This category of mutual funds invests in a portfolio of securities with a Macaulay duration of between three and six months. They are suitable for investors who are investing for a longer time and want to earn more than what liquid funds can offer.
Short duration funds
These funds invest in a portfolio of instruments with a Macaulay duration of between one year and three years. The level of risk is low, and they are not very sensitive to changes in the interest rate. They suit investors who want to earn more than what ultra short-term funds can offer.
Corporate bond funds
This type of mutual fund invests at least 80% of its total assets in corporate bonds of the highest quality. They are riskier than short duration funds and are suitable for investors who are looking for higher returns over a longer time.
Dynamic bond funds
This category of mutual funds invests actively across maturities in anticipation of interest rate changes. They are suitable for investors who are willing to take more risk to get higher returns in both rising and falling interest rate situations.
Credit risk funds
These funds invest at least 65% of their total assets in corporate bonds that are below the highest quality instruments. They suit investors who want to take on a higher risk of default to get more significant returns while avoiding risk related to interest rate changes.
Fixed maturity plans
This category invests in instruments with maturity profiles matching the fund’s tenure. They are suitable for investors who want to park their money for a fixed period at times when interest rate movements are uncertain.
They invest at least 80% of their total assets in government securities with different maturities. There is no risk of default, but they face a high level of interest rate risk as the underlying bond prices experience extreme fluctuations. They suit investors who can take a high level of risk and are looking for capital appreciation.
Debt mutual funds need to be part of you portfolio because debt and equity usually move in opposite directions. Debt funds reduce risk, provide stable returns, and help investors to withstand volatility. You need to know about the types of risk that debt funds face. If your risk tolerance is low, it may be best to stick to liquid funds, ultra short-term funds, and short duration funds.