How To Choose The Right Debt Fund?
There are 16 categories of debt funds and over 320 schemes to opt for. It’s no wonder that selecting the correct fund can be daunting for the most seasoned investors in the retail sphere. A fund selection that’s wrong can increase risks of generating returns that are below optimal or, worse still, capital erosion may occur. How to choose debt funds is crucial, and investors have to consider certain factors when making investments in debt funds. Before you make any investment, planning is of the essence, and this cannot be stressed more.
Understanding Self Time Horizon of Financial Goals
The start of any investment path begins by taking steps to learn about your individual financial goals. Financial goals are as distinctive as the investments themselves, and hence, once you determine what you want to achieve, and by when, your way of how to select debt mutual funds becomes clearer than when you initially began. Not only do you have to consider your goals and the horizon of their achievements, but also your own risk-taking capabilities. In accordance with these factors, you can decide what kinds of debt funds to select. Besides being aware of your own risk appetite, you should also know about the risks of investment in debt funds.
Understanding the Risks Involved in Investing in Debt Funds
How to choose debt funds the right way is not a challenge if you know what risks are involved in the funds themselves. Here are the two main risks involved in debt funds:
- Interest Rate Risks - Debt Funds invest your capital in bonds or debt instruments. Like stocks, bonds can be traded in daily markets. The prices of bonds go up and down, this being driven mainly by the way interest rates change, or how investors expect they may change. If interest rates drop, or investors think they will drop, bond prices rise. This is due to a high demand. For instance, suppose a debt fund holds a bond paying a 10% yearly interest rate. Now, if the economy’s interest rates drop, new bonds entering the market are bound to give lower interest rates, say 9%. As a result of this, demand for the previous bond with a higher interest rate goes up, leading to a rise in the bond’s price and the net asset value of the fund it belongs to. In a similar manner, if interest rates rise, bond prices drop. This is because, now, the demand for bonds paying lower interest rates drop. The price fluctuation of bonds because of interest rates is known as “interest rate risk”. When considering how to choose a debt fund, these price changes should be kept in mind.
- Credit Risks - You have probably come across credit scores, such as CIBIL scores. These reflect your credit worthiness as related to your credit history, and how well you have managed your finances. A credit score that is high means that you are financially sound. Similarly, companies have ratings too. Credit rating agencies like ICRA and CRISIL are two such agencies. These agencies evaluate a company’s financial information and historical data to know its capability for debt repayment. A rating is then assigned to represent this capability. A rating of AAA is the highest, indicating that a company will most likely repay debts and thus, is low in terms of credit risk. The lowest rating in a progressive rating system is that of D, assigned if a company has failed to settle its debts, and will probably be incapable of doing so in future. How to choose the best debt fund, and avoid these risks, would be to invest in debt funds that lend to corporates/companies with a high credit rating.
The Approach to be Taken when Investing in Debt Funds
After you know about the risks involved when deciding how to choose debt funds, you have to consider what approach to take before you start to invest. The approach you ultimately take always depends on you, and what kind of investor you are. These are the different approaches you can take when learning about how to choose debt funds for your ongoing investment:
- The Approach in Timing the Interest Rate - In this approach to investing in debt funds, the fund manager manages the risk related to the rate of interest in order to get optimal returns. The manager actively purchases and sells calls of bonds that have different tenures. You will discover that Dynamic Bond Funds proficiently use this strategy. Nonetheless, for the strategy to work, fund managers must get the timing of the rate of interest cycle right.
- The Approach of Credit - In this kind of approach, more returns are produced by mainly making investments in low-rated instruments which give high yields. These are called Credit Risk Funds. These funds may have some rate of interest risks, but risks from credit are prone to be greater than those generated by interest. A poor concentration of your portfolio in terms of the low quality of bonds held, means that you can view underlying losses of companies in case loan repayments are not undertaken in times of economic downturn.
- The Approach of Hybrid Funds - How to select the best debt funds with this approach has to do with fund allocation. Here, funds allocate 10% - 40% of their portfolios to equity to get enhanced returns. Conservative Hybrid Funds and Equity Savings Funds are instances of these. Such funds, according to the assets allocated, have differing degrees of risks, as in equity-oriented funds there is more risk than debt-oriented funds.
An Overview of Quantitative Indicators to be Used to Choose the Best Fund
When you wish to learn how to choose debt funds, you can use qualitative indicators like your personal time horizon for investment and risk variables. However, there are quantitative indicators that can help you pick the best debt funds according to your requirements:
- Modified Duration and Average Maturity - The weighted average of all current debt maturities held by a debt fund, is the average maturity of a debt fund. The modified duration in relation to a debt fund represents its sensitivity to changes in the rates of policy, or broader interest rates in the market. Debt funds that have modified duration and high average maturity have higher interest rate sensitivity to changes, allowing them to perform well in a regime of falling rates of interest. Debt funds having lower modified durations, and average maturities, perform best during interest rate regimes where there is an increase in interest rates.
- The ER, Expense Ratio - The expense ratio concerning funds represents their proportion of overall assets used for the meeting of overall expenses. The expense ratio’s importance as a parameter of how to choose debt funds is considered while picking from liquid, ultra-short, and low duration fund categories, as these possess limited upside potential relative to equity funds. Thus, choosing direct plans of debt funds is a good idea as they have lower expense ratios than other regular schemes.
- YTM, Yield to Maturity - The YTM of a debt fund is the weighted average yield of the parts of its portfolio. It gives you a clue about interest incomes that funds may accrue if all their portfolio constituents are being maintained till maturities. Debt funds that invest in fixed income instruments, and having higher coupon rates, have a higher YTM than any others. Nevertheless, the YTM can’t be the single indicator of potential returns out of debt funds, as actual gains depend on changes in “mark-to-market” valuations and the portfolio. Thus, you must account for the net YTM of any fund portfolios, which are, in fact, the gross YTM with the expense ratio subtracted.
How to select debt mutual funds is not so daunting now that you know what to base your pick on. There is always planning involved in any stage of investment and when you want to invest in debt funds, you must consider your own goals as well as characteristics of funds in question.
- Can I pick a debt fund based only on its AUM?
AUM refers to assets under management, and this is just one feature of any debt fund. There are other variables that must be considered, such as the credit risk, interest rate risk, the expense ratio, etc, that you must keep in mind
- While thinking of how to choose a debt fund, are quantitative factors important?
While considering any debt fund to make an investment in, quantitative measures such as the expense ratio, the yield to maturity, the modified duration, and the average maturity are crucial to investment decisions.
- What are the risks involved in investing in debt funds?
The main risks involved in investing in debt mutual funds are credit risks and interest rate risks.
- Why does the NAV of debt funds rise when interest rates fall?
The price of any single bond in a debt fund may be high. When interest rates in the economy fall, new bonds entering the market drop their rates. However, with the interest rate still high for the highly rated interest bond, there will be a great demand for this bond. This will take the bond price up, and the NAV of the fund house it belongs to.
- How do credit risks relate to investing in debt funds?
Debt funds have lending practices and lend capital to companies and corporations. If debt funds lend to corporations that have a high creditworthiness, you can be sure that the debt fund you invest in is sound.