What are Debt Mutual Funds? How to select the best Debt Mutual Fund?

What are Debt mutual funds?

Debt mutual funds give better returns than bank fixed deposits. They mostly invest in government securities, PSU bonds, bank certificates of deposit, commercial paper and corporate debt paper. Debt mutual funds are considered to give stable returns. One cannot say that debt mutual funds are risk-free. They come with certain risks. Selecting the right debt fund for your portfolio is as important and crucial as an equity mutual fund.

How to select the best Debt mutual fund?

Below is a guide that will help you select the right Debt Mutual Fund for your investment portfolio.

Match your duration with the investment horizon

Unlike equity funds, debt mutual funds are not suitable for long term investing. However, investments in a debt mutual fund can be done from anywhere between a month up to three to five years. It’s important to note that a debt mutual fund that is suitable for a month’s investment horizon is completely different from a fund that is for 3 years.

Therefore, as a first step, decide your investment horizon and identify the debt mutual fund suitable for the tenure. Funds with higher duration are likely to be more sensitive to interest rates. Modified duration is a measure that will help you assess the fund’s sensitivity to interest rates. This number will show the impact on your fund if interest rates were to rise or fall by 1%. Higher the modified duration, higher is the fund’s volatility. Long term funds have a higher modified duration.

Carefully select from the categories

After deciding on the duration, you need to pick a category for your investment. There are 16 categories that SEBI has classified for Debt Mutual Funds. All these categories are restricted based on certain conditions. For example, low duration funds, short-duration funds, long-duration funds, etc. with how short-term or long-term scrips they could invest in. Other categories like corporate bonds or credit risk funds are restricted based on the credit ratings of the underlying scrips. Therefore, based on your investment objective and investment horizon pick the right match for your portfolio.

Returns or Safety in a debt mutual fund?

Be it any investment, the risk is inevitable. Yes, even debt mutual funds are risky. Only that the level of risk is low. To earn high returns, you need to be able to tolerate the corresponding risk attached to it. The recent debt market crisis has proved that debt mutual funds are risky. Certain risk is healthy for investments; you need to understand how much risk you are willing to take. The usual strategy for investing is to choose equity funds for capital appreciation and debt funds for parking money. Liquid funds are the best alternatives for holding cash in your savings bank account. Even if you are not a risk-taker, for all your long term investments certain equity exposure is recommended.

Don’t be under the impression that debt funds are 100% safe, to earn returns from debt mutual funds be ready to take the accompanying risk. Typically, there are 2 types of risks:

Credit Risk

Credit Risk is the possibility of borrower’s default. It is very hard to predict this risk. Therefore, it’s best to go by the ratings of the instruments that the fund has invested in.

Interest Rate Risk

Interest rates ups and downs result in unnecessary volatility. It is good if you are able to get your interest rate outlook right and are able to rebalance your portfolio accordingly. This is easier said than done. Complications like taxes will find their way and make it difficult to manage your investments. Therefore, short term funds are best to overcome interest rate risks.

Avoid funds with a high expense ratio in a debt fund

It’s easy to understand the source of risk associated with debt mutual funds. High returns for a debt mutual fund are because of the high risk the fund is taking. A debt mutual fund with high returns and high expense ratio would be taking higher risks. Therefore, if you aren’t the risk-taking type, best avoid debt mutual funds with high expense ratio.

Go with reputed mutual fund houses and big funds

Big fund house(AMC) may have a greater reputation to salvage. In a fund with bigger corpus the concentration of risk is lower. In a scenario when the fund portfolio is experiencing a default the impact on the fund’s NAV is not going to be too high.