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Guide on How to Choose the Right Debt Funds - ABSLMF Blog

Guide for Choosing the Right Debt Fund

Sep 28, 2018
6 mins | Views 1282

Unlike Equity funds, Debt mutual funds are complicated to understand and for most of us choosing the right debt fund is a major task.

Should you invest in a liquid fund, a short-term fund, a dynamic bond or a credit risk fund? How to know which fund would best suit your needs?

Unless, you are willing to dive deep down into fund literature, the answers may not be easy to find.

Good news is that recently SEBI has defined different and specific categories for mutual fund schemes with an aim to help investors select their schemes with more ease.

There are now 16 categories of debt fund each serving a different purpose. To choose the right category, first of all you have to determine for what purpose you are investing, for how long you would remain invested and how much risk you are willing to take.

Your purpose or investment goal could be keeping money aside for payment of your kids’ school fees due in the next 2 months (capital preservation) or accumulating down payment for your home over 2-3 years (capital preservation with some growth) or simply investing in debt for long term to diversify your equity investment portfolio (capital preservation and growth).

Now let’s see how your INVESTMENT GOAL along with TIME HORIZON and RISK APPETITE can help you choose the right debt fund:

  • Low Risk / Short Term Goal (0 - 1year):

    When you are investing for a very short period, capital preservation or safety of your capital money is priority even at the cost of lower returns. Hence for all your short term money requirements, you can consider investing in Liquid, Ultra Short Duration or Money Market funds depending upon the time horizon you wish to invest for.

    Investors having some more appetite for risk may also consider Low Duration funds (Moderately Low Risk) for their short term goals.

    Interest rate and credit risk involved is minimal in these categories. These funds can also be used for doing STPs (Systematic Transfer Plans) to equity funds or to start SWPs (Systematic Withdrawal Plans) for regular income.

    *Moderately Low risk involved

  • Low – Moderate Risk / Medium Term Goal (1-3years):

    When investing for a slightly longer tenure, you can aim for relatively better returns along with the preservation of your capital money by taking some risk.

    For medium term goals, you can consider Low Duration, Short Duration funds, Corporate Bond funds, Government Securities funds, Banking & PSU Debt funds, which have the potential to offer better returns.

  • Moderate Risk / Long Term Goal (More than 3 yrs):

    When you are investing for long term and have the appetite for higher risk to earn that extra return, you can consider investing in funds like Medium Duration funds, Credit Risk funds, Dynamic Bond funds, Long Duration Debt funds etc. These funds involve both credit risk as well as the interest rate risk but at the same time have the potential to deliver better returns over the longer term.

  • Once you have chosen the debt fund category which suits your investment goal, time horizon and risk profile, you can zero down on the right fund for you. Here are a few parameters that can help you narrow down your list:

    1. Expense Ratio

      Debt funds tend to keep their expenses low to provide investors the maximum benefit. A higher expense ratio could create a huge impact on the fund performance and leave you with little returns. Hence keep an eye on the same.

    2. Portfolio Quality

      This refers to the credit quality of portfolio. It is advisable to choose fund which primarily invests in top rated instruments (Sovereign, AAA, AA, etc.) Good credit quality ensures that your fund scheme is safer. This may reduce the returns a bit but your money would be relatively safer.

    3. Investment Strategy

      There are two major investment strategies that are adopted by Debt fund managers:

      • Duration

        There is an inverse relationship between debt fund returns and interest rates. If interest rates go down, debt fund returns go up & vice versa.Here the fund manager understands the interest rate environment and then positions the portfolio to benefit from changes in interest rates. This enables him/her to generate capital gains. The interest rate risk is high in these funds as they may lose capital if interest rates don’t move in the expected direction. Most of the Long term bond funds use this strategy.

      • Accrual

        Under this strategy, a fund invests in short term instruments with an intent to hold the investment till maturity and earn the interest. Hence the interest rate risk is lower in these funds. These funds are safer and have low volatility in their returns.

      • Duration strategy gives higher returns with high volatility while the funds adopting accrual strategy are less volatile and deliver risk commensurate returns. You should choose the fund according to your risk appetite.

    4. Track record

      A fund house and a scheme with a track record of managing money, without taking undue risks, is also very important. So choose wisely!

If you are still confused and are not able to choose the right debt fund for you, it is best to work with your financial advisor to select the right one for you.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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