Given that people spend far more time and effort selecting equity funds over debt funds, one might assume that choosing the latter is simple. On the other hand, establishing a debt fund is more difficult because of the several categories available—liquid, income, short-term, ultra-short-term, monthly income plans, gilt, fixed maturity plans, and so on.
Though the essential criteria for selecting a fund are the same across all categories—risk profile, consistency in performance, and fund manager’s track record—there are additional elements to consider when investing in a debt fund.
The sharp drop in FD rates may soon tempt low-risk investors and those wishing to park short-term surpluses to choose debt mutual funds as an alternative. After all, lower interest rates result in better returns from debt funds. With over 16 debt fund types and over 300 debt funds from which to choose, selecting the wrong fund might result in sub-optimal returns or capital erosion.
Here are the seven key factors for selecting a debt fund:
Time and Fund Maturity
As a debt fund investor, you could first determine how long you want to keep your money in the fund. This is because each category’s maturity profile is unique. It would help if you tried to match your investing time horizon to the funds.
So, if you’re searching for a three-month investing horizon, stay away from liquid funds. Instead, invest in ultra short-term funds, with an average maturity of up to 90 days for the underlying paper. Income funds or fixed maturity schemes are the ideal alternatives for people who want to invest for a year or more.
Interest Rate Scenario
Current interest rates determine debt funds’ value. Debt funds lose value as interest rates rise and vice versa. This is because interest rates and bond prices have an inverse relationship. On the other hand, short-term debt instruments are less vulnerable to rate changes than long-term debt instruments. When interest rates climb, it’s a good idea to switch to short-term funds.
Liquid funds, backed by liquid plus funds, are the safest investments. In a rising interest rate scenario, funds with marked-to-market risk, including such income funds or long-term gilt funds, tend to underachieve over the medium to long term.
Size of the Fund
While it is possible to claim that size does not matter in equity funds, it does in debt funds. A limited corpus may not be detrimental to equity fund investors, and it may be detrimental to debt fund investors. This is because a small corpus may not have been able to fulfill large-scale redemptions if a debt fund encounters large-scale savings.
The fund manager will benefit from a high corpus since he will be in a stronger position to sell securities dealing with redemptions. Without liquidating its holdings, a vast fund can cover such needs from its cash reserves. A fund manager in charge of a much smaller plan will not have the same level of freedom.
Examine the fund’s investment allocations among various debt products, such as commercial papers, certificates of deposits, gilts, treasury bills, corporate bonds, non-convertible debentures, and government bonds. The next step is to see if the distribution aligns with the scheme’s goal. It also aids in determining the risk concentration in the portfolio.
The performance of debt funds is also tested against even a benchmark index. This allows you to observe how the fund has fared over time compared to its benchmark.
Yield to Maturity
Yield to Maturity (YTM) is among the indications of a fund’s perspective returns to investors.
Two factors influence YTM. One factor is the fund’s duration: longer-term funds have higher YTM. The credit quality of the bonds in which the plan invests in the second factor: lower-rated securities offer higher returns than higher-rated securities. A higher YTM indicates a higher chance of higher rewards and risks.
The expenditure ratio is crucial for a debt fund, unlike an equity fund, because the returns are minimal. Given that most debt funds offer returns of 7-10 percent, having an expensive cost base will significantly impact returns.
As a result, investors should ensure that the expense structure is acceptable and in line with the fund’s performance. It doesn’t make sense, for example, to pay a 2.25 percent fee for a return of 3-4 percent or less. You effectively receive a negative return on the investment if you adjust for inflation.
Debt funds are a significant portion of one’s asset allocation. However, before deciding which fund to invest in, it’s critical to determine which category best meets one’s risk appetite and investment horizon. It’s important to remember that Debt Funds should be used to stabilize your portfolio rather than for more significant returns.