When we think about investment in mutual funds then first option we all think about is Equity Funds or Diversified Funds, and in this post I will explain how to choose the right Debt Fund. First, lets see what is Debt Fund.. A debt fund is a professionally managed funds, which invest money in Government Securities, Money Market Instruments & Corporate Deposits. These mutual funds include a small percentage of equity investment of around 10% in their portfolio to give investor capital appreciation. So, debt fund are associated with little investor risk too.
Most of the mutual fund investor think that choosing a debt fund is easy then chooising equity fund whereas on contrary, I would like to say selecting a debt fund is more problematic because of large number of categories available - Liquid, Income, Short-term, Ultra Short-term, Gilt, Monthly Income plans, Fixed Maturity plan etc. Though fund selection requires some basic criteria - risk profile, consistency in performance, quality of underlying paper & fund manager's track record etc.
Key parameters for choosing a right Debt Funds are:-
Time Horizon & Fund Maturity - If you want to go for debt fund then first, you should ascertain the period for which you want to stay invested because each category has different maturity profile. Ideally, investor need to match its time horizon with that of the fund.
For example :- you are looking for investment for a period of 3month then investor should not invest in liquid or short-term fund instead they should go for Ultra Short-term fund where average maturity of fund is upto 90 days. For 1 year or more, Income fund or fixed matruity plans are the best option.
Note :- Short-term gains in debt funds are taxed according to the applicable tax slabs whereas Long-term gains are eligible for the inflation indexation benefits.
Quality of underlying papers - Before investment in debt fund investor should scrutinised the quality of debt instrument in the fund's portfolio. Every instrument is assigned a credit rating that signifies the level of default risk. Higher the rating, the safer the instrument. To check whether the instrument are safe or not, investor can go through the offer document as well as the subsequent fact sheet publised by the mutual fund. A debt fund may invest in number of instrument ranking from risk-free goverment securities to high-risk corporate paper As the safety of capital is of utmost importance to a debt investor and a fund holding large amount in a poor quality paper may find it difficult to sell such securities in the market, thereby putting the money at risk while its true that a debt fund with a risky paper is likely to yield higher returns, it may work unfavourably for the investor. So, investor should go for funds which have low quality investments.
Interest Rate scenario - Debt mutual funds are exposed to interest rate risk as they tend to go up in value when interest rate fall and vice-versa. This is because of the inverse relationship between bond prices and interest rate. However, short-term debt funds are less sensitive to movements in interest rate in comparison with the long-term funds. So, it is advicable for investor that when interest rate are on the rise it makes sense to move to short-term funds and vice-versa.
For example:- if you had invested in a deposite one year ago, you could have got 10% annual rate of return. A similar deposit today would fetch only a 7% per annum rate of return. If you were allowed to get the 10% per annum deposit today, you would probably be willing to pay a premium for it.
Expense Ratio - Debt funds have lower returns, expense become very critical as a higher expenses ratio eats into the investor's returns. As most of the debt funds offer returns in the range of 7%-10%, having an expensive cost structure will be huge drag on the returns. So, it is very important for investors to ensure that the cost structure is reasonable & in line with the return being offered by the fund. For example:- it doesn't make sense to pay a charges of 2.25% for a return of 3-4% and if you adjust for inflation then you are effectively earning a negative returns on your investment.
Size of the fund - While one can argue that size doesn't matter in equity funds, in the case of debt funds, it does assume greater significance. A small corpus may not hurt equity fund investors, but could affect debt fund investors. From time to time, debt mutual funds could see large redemptions, as happened in the case of Lehman Brothers crash. If the fund size is large, the fund manager can meet these redemptions out of his cash holdings. He also has more choice regarding which instruments to sell off to meet these redemptions. The manager of a small fund doesn't have as much leeway and has to perforce book losses. Hence, while in equity funds a large fund size can pose problems (the fund manager needs many more investment ideas to earn high returns), in debt funds large size can be an asset as it helps produce stable returns.
Fund Manager's track record - Past performance data for a debt fund no longer remain relevant if the fund manager who bring back those returns has left the fund. A good investment strategy would be to track the performance of star fund managers and move your investment with them when they move from one fund to another. If the fund manager is same and fund performance is consistent across interest rate cycles, it implies the fund manager is moving smartly between different types of debt instruments and making the most of the volatility.
These are the factor which an investment need to analysis investing in debt fund. At the end, I would like to say "In financial markets, the fastest does not always win; the winer is the one who is better prepared and more balanced."
