Despite its fair share of ups and downs, the stock market is still one of the best places to put your money to work. Of course, this is hard to believe for those of us who have a lower risk appetite and have been conditioned to save rather than invest. However, if you are tentatively testing the proverbial market waters and still not ready to risk big to earn big, then debt funds, a mutual fund investment, certainly deserve your consideration.
Debt funds, as you can guess from the name itself, are a type of mutual funds that invest in low-risk and fixed income instruments such as bonds, debentures, treasury bills, and government securities. With sufficient diversification, debt mutual funds promise dependable returns for short to medium term investments. Even though debt funds are inherently low on the risk spectrum, they are still susceptible to risks associated with liquidity, credit, and interest rates.
Therefore, pay attention to certain critical factors when choosing a debt mutual fund to invest in.
This article covers:
- Historic performance
- Interest rate regime
- Duration and maturity
- Credit risk to portfolio constituents
- Expense ratio
- Yield to maturity
First, if the debt funds you are considering for your mutual fund investment have been around for a while, make sure to check their performance record. Although a fund’s historic performance gives no guarantee of its future performance, it does tell you how well the fund’s AMC has managed the investor’s money so far.A fund’s historic performance gives no guarantee of its future performance Click To Tweet
A trend projection can help you set your expectations for future returns and decide how much to invest in the fund.
Interest rate regime
Debt funds are innately sensitive to the prevalent interest regime because they invest in the bond market. In a falling interest rate regime, existing debt mutual funds experience capital appreciation as previously issued bonds have a higher coupon rate. Conversely, in a rising interest rate regime, newly issued bonds and securities offer better coupon rates, thus negatively affecting debt funds’ performance.
Therefore, checking the current interest rate regime becomes a key factor in the selection of debt funds.
Duration and maturity
The Net Asset Value (NAV) of debt mutual funds is also affected by the changes in the interest rate, which impacts the average maturity and duration of a fund. Generally, debt funds maturing after a longer duration are more volatile and perform well in a falling interest rate regime. Shorter duration debt funds are comparatively more resilient and perform well even in rising interest rate regimes.
Thus, to maximise your returns, make sure to check the average maturity and modified duration of all debt funds in your consideration set.
Credit risk of portfolio constituents
Before you invest in mutual funds, it’s common practice to check their asset allocation or portfolio constituents. The same is true for debt funds. A fund factsheet can offer complete information about the credit ratings of the portfolio constituents that make up the fund. A credit rating of AAA is indicative of the lowest risk of default and is usually accompanied by conservative returns. Alternately, a higher credit risk exposure may come with higher returns.
You can, therefore, select the debt fund, which comprises securities and invests in bonds whose creditworthiness matches your risk appetite.
You also need to keep an eye out on your selected debt funds’ expense ratio, especially since it can have a palpable impact on your net earnings. The expense ratio is the sum total of expenses incurred by an AMC in running the mutual fund and is subject to change from time to time. It includes trustee fee, fund manager fee, distributor commission, and other recurring overheads.
A high expense ratio can significantly reduce your return, and therefore, you should carefully consider it before committing your money.
Yield to maturity
The final thing to consider while assessing the attractiveness of a debt fund is its yield to maturity. The average weighted yield of a fund indicates the expected interest income which the fund can accrue. YTM or yield to maturity denotes that income in the event that all the portfolio constituents of the debt fund are held till maturity.
Of course, YTM in isolation can’t help you make the right choice as a debt fund’s performance can vary with market conditions and changes in portfolio constituents. Still, by deducting the expense ratio from the gross YTM projected by a debt fund, you can get a fair estimate of its potential return.A trend projection can help you set your expectations for future returns and decide how much to invest in the fund Click To Tweet
In addition to these factors, your own investment objectives, risk-taking abilities, and understanding of financial market instruments can also influence your decision. You must remember to do thorough research and assess credit/liquidity risk before parking your money in debt mutual funds.
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