Choosing the Right Debt Fund for Your Investment Goals: Tips & Strategies for Successful Investing

Vinod Singh, a 65-year retired engineer living in Mumbai took a relook at his investment portfolio a few years before retirement. At the start of his investment journey, he invested a large chunk of his capital in equity funds as he wanted it to grow fast. He also invested a smaller sum in debt funds to balance the risk.

His aggressive investment strategy paid off and he was able to meet his financial goals including his daughter’s international higher education. A few years before retirement, Mr. Singh rebalanced his portfolio and invested the majority of his capital in debt funds. To ensure the security of his capital and meet his expenses during his retirement years, he opted for the safety of debt funds.

What are debt funds?

Debt funds are mutual fund schemes that invest the corpus in fixed-income securities, corporate and government bonds, certificates of deposits, commercial papers, treasury bills, and other money-market products. Although debt fund investments are safer than equity mutual funds, they are not completely risk-free. Debt funds have two types of risks:

• Credit risk

  CIBIL score for individuals shows how well they manage their debt obligations and determine their creditworthiness. Similarly, credit rating agencies like ICRA and CRISIL look at a company's financial statements and past performance to determine its debt repayment capabilities before assigning a rating. The highest rating is AAA, which indicates the lowest risk and goes all the way down to D, which indicates past defaults or the company's incapability to meet future debt obligations. The best way to mitigate credit risk is to choose debt funds that invest in instruments with higher ratings.

• Interest rate risk

  Like company shares, bonds are also listed on stock exchanges and traded, which means their prices can increase or decrease. The prices are generally determined by the changes in interest rates and the future expectations of their movement. If interest rates decrease or are expected to reduce, bond prices go down and vice versa. This price movement is known as interest rate risk.

How to choose the right debt funds?

How to choose debt funds can be cumbersome as these are more complicated than equity funds. There are multiple categories of debt funds and to choose the right fund, you first need to determine your investment purpose, time horizon, and risk appetite.

Investment goals can be short-term for example keeping aside the money needed to pay for children's school fees in three months. Another goal can be to accumulate the amount needed to make the down payment on your home. A third investment purpose can be diversifying your portfolio for the long-term.
Here is how investment purpose, time horizon, and risk appetite can help you choose the right debt fund for your portfolio:

• Short-term goal with low risk

If your investment purpose is short duration, capital preservation becomes important even if the returns are lower. In such cases, liquid, money-market, or ultra-short-duration funds can be opted for. If you have a slightly higher risk appetite, you may invest in low-duration funds. The credit and interest rate risks are minimal and these funds can be also used to start an STP for equity funds or an SWP for periodic income.

Also read about: What are Ultra Short Term Mutual Funds?

Medium-term goal with low to moderate risk

If your investment purpose is in the medium-term, you can opt for capital preservation with some growth by assuming moderate risk. Some debt funds for the medium term can include low duration, corporate bonds, government securities, short duration, and banking and PSU debt funds.

Long-term goal with moderate risk

For an investment goal spanning the longer term, you can assume a higher risk and aim for capital appreciation. Some available options include credit risk, long-duration, dynamic bonds, and medium-duration debt funds. Though the risks are higher, these can potentially deliver higher returns.

After determining which debt oriented mutual fund, you should consider the following factors to make the right investment decision:

• Expense ratio: A higher ratio can reduce the actual returns on your investment

• Portfolio quality: Opting for funds that include higher-rated instruments will increase the possibility of higher returns

• Track record: A fund house with schemes that have a consistent track record without assuming unnecessary risks is a better option

Still confused? Choose a reliable and experienced financial advisor to ensure security and peace of mind just like Mr. Singh did.

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