How to Choose the Right Debt Fund For Your Portfolio?

Before understanding where to invest money, an individual should first understand his personal investment goals, i.e., when the money will be needed and his / her risk-taking capacity. Debt funds invest in bonds issued by companies and governments which may either be categorised on the basis of maturity tenure or nature of the bond.

The table below suggests the debt funds best suited to meet your investment horizon:

Debt funds	Underlying Security
Overnight funds	Overnight  securities with a maturity of 1 day
Liquid funds	Debt    and  money market  securities  with  maturity  of up to 91 days
Ultra-short duration funds	Investment in debt and money market instruments such that the Macaulay duration  of  the  portfolio  is  between 3 to 6 months
Short duration funds	Investment in debt and money market instruments such that the Macaulay duration  of  the  portfolio  is  between 1 to 3 years
Credit risk funds	65% minimum  investment  in  corporate bonds – (investment  in low  rated instruments)
Gilt fund	80% minimum investment in government securities (across maturity)
Banking and PSU Funds	80% minimum     investment     in     debt instruments of banks, public sector undertakings, public financial institutions
This is not an exhaustive list of debt fund categories. This is also not a recommendation that one should invest in only these debt funds. Please research well before investing.

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Quick Take: What is Macaulay Duration? Macaulay duration is a measure of how long it takes for the price of a bond to be repaid by its internal cash flows. It is used only for a debt instrument with fixed cash flows.

Debt funds are considered less risky than equity funds. Amongst the debt funds, liquid funds have a very low risk while Gilt Funds & Bond/Income Funds are riskier. Further, investors should also consider the credit rating given by credit rating agencies – which ranges from AAA+ to D, AAA+ being the highest. 

In simple words, a fund with a higher rating is safer than a fund with a lower rating. Funds with lower ratings tend to offer higher interest rates. Risk and returns go in opposite directions. While a high returning instrument will be risky, a low returning one mostly has a moderate risk profile. 

Hence, it is important to keep in mind your risk appetite before investing in a debt fund.

Risks Involved in Investing In a Debt Fund

Typically, there are 2 major risks involved while investing in a debt mutual fund – interest rate risk and credit risk.

Interest rate risk is the risk of fluctuation of the interest rate. Interest rate and Net Asset Value (NAV) are inversely related, i.e., if the interest rate increases, NAV falls and vice versa. The interest rate risk mostly does not impact the immediate short term funds but impacts the NAV of long duration funds.

Credit risk is the risk that the fund may not pay on time. Credit rating agencies like CRISIL and ICRA give ratings to mutual funds. Credit ratings keep on changing from time to time. For example, if the fund holds papers that are downgraded by the market, the fund may also get a lower credit rating and consequently a lower NAV.  

Assets Under Management (AUM)

AUM means the market value of investments held by a mutual fund. Debt mutual funds rely highly on their AUM to manage their returns and dividends to investors. A debt mutual fund that has a high fund size or larger assets under management is in a better position to distribute fixed fund expenses across its investors. A large fund size would mean a lower expense ratio per person which in turn gets reflected in the fund returns. 

Also, if the fund house has a larger fund size or assets under management, it helps in negotiating better with the debt issuers courtesy the size.

Weighted Average Maturity Of the Fund

A debt fund invests in various debt instruments having different maturities. Depending on these maturities, one can determine whether the fund is short term, medium-term or long term.

Weighted average maturity is calculated by considering the maturity period of an asset held by the fund and the weightage of that holding in the fund’s total assets. Funds with a higher weighted average maturity can deliver greater returns due to their ability to hold longer. However, there is a greater risk associated with long-duration funds due to interest rate fluctuations. As a result, there may be more fluctuations in the NAV of the fund.

Key Takeaways

1. Choose a debt fund whose duration matches with your financial needs. 
2. Liquid and overnight funds carry the lowest credit risk, ultra short term to short term funds are moderately riskier, and the long duration funds carry the highest risk amongst the debt funds. 
3. Ratings provided by the credit rating agencies must be a guiding factor. 
4. Higher AUM of a debt fund indicates good public response and success of a debt fund.
5. A fund with a longer weighted average maturity is riskier than a fund with a lower weighted average maturity. 

General FAQs About Choosing the Right Debt Fund:

• Can I choose a debt fund solely based on its AUM?

The answer is no. Let’s assume that an individual finds that ABC Fund has a huge AUM and a credit rating of AAA+. However, the fund has a very high weighted average maturity. It means that the ABC Fund holds many long-term investments and may be subject to interest rate fluctuations in the long term. If the individual does not wish to take that risk, he may decide to go for a lower weighted average maturity fund. Also, deciding where to invest solely based on one factor can be misleading.

• Why does the NAV rise when the interest rate is falling?

When the interest rates are falling, investors will flock to invest in funds that hold debt papers of a longer maturity at high-interest rates, and consequently, the NAV of that debt fund would rise. In a reverse situation of rising interest rates, the NAV of a debt fund would reduce.

Happy Investing!

Ref : https://groww.in/blog/how-to-choose-right-debt-fund/