How to Select a Debt Fund
Selecting a debt fund to invest in can be tricky as there are too many options available. In this article we will list down steps to select a debt mutual fund.
- Investment Horizon
Investment in equity funds is done for Long term and further classification is done basis the risk appetite of the investor. However, Debt funds suitability is based mostly on the investment horizon. There are different types of debt funds available for different investment horizons. Here is a list of them:
A. Liquid funds : 0-3 months
B. Ultra short term funds : 3 months – 1 year
C. Short Term funds : 1 – 3 years
D. Intermediate/Long Term funds : More than 3 years
- Interest Rate Risk
There are two major investment strategies regarding the Interest Rates that are adopted by Debt fund managers. These are:
A. Duration: Debt fund returns and Interest Rates have inverse relationship. If interest rates go down, debt fund returns go up. Hence the fund managers adopting Duration strategy invest in Long Term bonds so that they can benefit from any fall in interest rates. The interest rate risk is high in these funds as they may lose capital if interest rates move up. Most of the Long term bond funds use this strategy.
B. Accrual: The funds which follow this strategy invest in short term instruments and hence the interest rate risk is lower in these funds. These funds hold the securities till maturity to reduce the interest rate risk even further. These funds are safer and have low volatility in their returns.
Duration strategy may give higher returns but it is more risky and Accrual strategy is less risky but returns may be lower. You have to choose the fund according to your risk appetite. There is one more strategy which is adopted by Dynamic bond funds.
Dynamic Bond Funds: These funds can invest across instruments of different time horizon. The fund manager takes a view on the interest rates and invests accordingly. The risk in this strategy lies in between the risks associated with Duration and Accrual strategy and an experienced fund manager with a good track record matters a lot in these funds.
- Beware of exceptionally High Return
If you see a fund with higher returns than its peers then you must check that where are these returns coming from. The debt instruments carry a credit rating assigned to them, the better the credit rating the safer the instrument is. The instruments with lower credit ratings offer higher returns to compensate for their credit ratings. Hence, before investing in a fund giving higher returns, check its portfolio to find out if it is over exposed in low credit rating instruments. If the credit rating of an instrument is very poor then liquidity risk also arises and it is tough to find avenues to sell that instrument.
- Fund size
Since liquidity is lower in debt markets, the fund size becomes important factor while selecting a debt fund. If the fund size is small then if there are substantial redemption requests then fund performance may be affected. On the other hand a well sized debt fund will provide sufficient options to the fund manager if substantial redemption requests are there.
Since the returns from debt funds are lower than that of equity funds, a high expense ratio can reduce the returns. Go for direct plans which have low expense ratios and even then compare with other direct plans. The other cost involved is Exit load. Check out if the exit load matches with your investment horizon or not.
In debt funds safety of capital should be primary concern. However, shortlist funds based on the above criteria and also then check the returns too. Do not select a fund giving poor returns even if it checks out the above mentioned points.
Next Read: How to select an equity mutual fund?
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