How to choose debt funds

If you are an investor looking to balance risk and returns and maintain a stable investment portfolio, selecting the right debt fund is crucial. Debt funds can provide a steady income and are less volatile than equity funds. To invest in debt funds, you must understand terms like investment horizon, risk appetite, and market dynamics.

In this article, we will see how to choose a debt fund wisely after examining all these factors.

How do you select debt funds? Key factors to consider

When choosing the right debt fund, you must evaluate factors such as investment horizon, risk appetite, associated risks with the investment, and types of debt funds.

1. Understand your investment horizon and risk appetite

The first step towards choosing a suitable debt fund is understanding your investment horizon and risk appetite. If you prioritise liquidity or need to liquidate the funds within a short period, a short-term debt fund is best suited for you. On the contrary, long-term debt funds will offer better returns if you wish to secure funds for a long period. Understanding your risk appetite is also crucial at this juncture. A debt fund with a lower credit risk is best suited if you are a conservative investor. Conversely, if you have a higher risk tolerance, you can consider debt funds with higher returns but are more volatile.

2. Know about the different types of debt funds

Here’s a complete breakdown of the different types of debt funds and their characteristics that you must understand to make an informed decision:

Know about the nature of different debt funds

Every debt fund has some distinct characteristics that will affect its performance. Ultra-short-term duration and liquid debt funds offer higher liquidity and are not much affected by interest rate changes. On the other hand, while long-term debt funds are affected by changes in interest rates, they provide higher returns, even in a stable or declining interest rate environment. A third variant, the corporate bond and credit risk funds, offer higher returns. However, they come with increased credit risk, so the likelihood of issuers defaulting is higher.

Two risks involved while investing in debt funds

The two major risks involved when investing in debt funds are:

Interest rate risk

When there are changes in the interest rates, it will affect the value of the debt mutual fund investment. Hence, interest rate risk is important to understand. Typically, when interest rates begin to increase, the prices of existing bonds begin to fall. This reduces the value of the fund’s holdings. However, when interest rates begin to fall, bond prices start to rise. Debt funds with long-term duration are more sensitive to changes in interest rate, while funds with short duration are comparatively less affected.

Once you adjust the duration of your investments, you can mitigate the interest rate risk. If you anticipate a rise in interest rates, you can choose a shorter-duration debt fund and reduce your exposure to interest rate risk. Similarly, if you expect a decline in interest rates, choosing a long-duration fund can help capitalise on the increase in bond prices.

Credit risk

Credit risk is the risk you run if the issuer of your bond defaults on its payments. This kind of risk is higher in funds invested in low-rated corporate bonds. Of course, higher credit risk leads to higher returns, but the disadvantage is that if the issuer defaults, the potential for losses increases.

It is a prerequisite to check the credit ratings of the securities the debt fund holds to manage credit risk. Debt funds that invest in high-rated securities may offer lower returns but are generally safer. As an investor, you need to balance your desire for higher returns with your credit risk tolerance.

Diversification

One way to efficiently select debt funds is diversification. You can spread your risk across a mixed bag of debt funds with varying durations and credit risks. This could enhance your returns. Diversifying helps when a particular debt fund investment has performed poorly, but the others have done well, so it does not affect the overall portfolio to a great extent.

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Factors to consider before investing in debt funds

There are various factors to be considered in order to invest in Debt funds:

1. Shift in the interest rate cycles

It is extremely crucial to understand the interest rate cycle. Investing in long-term debt funds when the interest rates are rising can lead to losses. On the contrary, if interest rates are declining, then investing in long-duration funds can be beneficial.

2. Risk-return balance

Maintaining a balance between risk and return is essential. One way to do that is to assess your tolerance to risk and then choose debt funds that match this risk-taking profile. If you choose the ones that offer higher returns, remember that they will also come with higher risk.

3. Modified duration strategy

Modifying the duration of the debt fund helps measure how sensitive it is to interest rate changes. Funds with a higher modified duration are more affected by changes in interest rates. Whatever your outlook on interest rates, choose funds with a duration that aligns with it.

4. Bond prices

Keeping an eye on bond prices is also crucial, as they affect the Net Asset Value (NAV) of debt funds. Understand how market conditions affect and influence bond prices to make a more informed decision about debt fund investment.

5. Inclusion of Indian bonds in foreign markets

When Indian bonds are included in global indices, they attract foreign investments, which affects bond prices and yields. You should stay on top of these developments.

6. Strategic investments

Seek advice from financial advisors and have them tailor your investment strategies. Base such strategies on your financial goals, outlook towards the market, and risk appetite.

List of debt mutual funds in India

1. Aditya Birla Sun Life Medium Term Plan Fund
2. UTI Medium to Long Duration Fund
3. HDFC Regular Savings Fund
4. Sundaram Low Duration Fund
5. ICICI Prudential Gilt Fund

Key takeaways

• Understand your financial needs and choose the duration of the debt fund based on them.
• Among debt funds, liquid funds carry minimum credit risk, ultra-short-term to short-term funds carry moderate risk, and long duration funds carry the highest risk.
• Read up on the ratings given by credit rating agencies and rely on them.
• Diversify your investments.
• Remember to understand factors like interest rate cycles, risk returns balance, modified duration, and bond prices before you invest.

Conclusion

Before you choose the right debt fund to invest in, carefully research and analyse every aspect. Make sure it aligns with your financial goals and risk tolerance. Choosing the right debt funds involves careful consideration of various factors to align with your financial goals and risk tolerance.

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