How To Select The Right Debt Fund?
Investment instruments are subjective to individual investments goals, and hence, there is no fixed instrument that might meet everyone’s needs. A debt fund can be proven right or wrong for you depending upon how well it meets your investment objectives, while also taking care of your risk appetite.
Here’s how you can assess if a debt fund is suitable for you or not:
- Investment Horizon: It refers to the time period for which you wish to stay invested in a debt fund, it could be as short as a day and as long as 10-20 years. Overnight funds feature the shortest average maturity, i.e. of 1 business day. On the other hand, debt funds holding securities with long average maturity periods include long duration funds and gilt funds.
- Risk Appetite: While all debt schemes feature interest rate risk, credit risk, and inflation risk, the degree of risk varies from fund to fund. Liquid funds and overnight funds carry the least amount of interest rate risk, a gilt fund features the least amount of credit risk. Read more about the risks associated with debt funds.
- Interest Rate Trend: During an upward trend in interest rates, it is wiser to invest in short duration funds rather than long duration funds. This is because with increasing interest rates, the modified duration of long duration debt funds will be higher. Similarly, longer duration debt funds are favourable in times of declining interest rates.
A debt fund is a type of mutual fund which invests a majority of its assets in fixed-income securities such as corporate bonds, sovereign securities, certificates of deposit (CDs), commercial papers and various other debt and money market instruments.
As per SEBI (Securities and Exchange Board of India), the capital money market regulator, there are as many as 16 types of debt funds such as overnight fund, liquid fund, medium duration fund, long duration fund, etc. Thus, it is imperative to learn about the types of debt funds and then select the debt fund which best suits your investment requirements.
However, before proceeding with the parameters on which you should evaluate a debt fund, let’s get familiar with certain terms associated with debt schemes.
- Average Maturity:
A debt fund invests in a number of debt and money market securities; each security in the portfolio may have a different maturity date. The maturity date of a debt instrument refers to the specific date in the future, when an investor will be repaid his/her principal investment amount by the issuer of the debt instrument.
The average maturity of a debt scheme is the weighted average of the maturity periods of all the debt instruments held by the issuer it in its portfolio. Average maturity can be calculated in days, months or years. For instance, the average maturity of a debt fund is 7 years; this implies that on an average, all the securities held by the fund will mature in 7 years.
However, the maturity period of individual securities may be more or less than 7 years. Generally, the longer the average maturity of a debt fund, the higher is the risk associated with it.
- Yield To Maturity (YTM):
The yield earned on a bond is different from its coupon rate. While the coupon rate refers to the fixed interest rate that an investor will receive on his/her debt investment, yield refers to the fixed interest rate earned in relation to its purchase price.
For example, let’s take the face value of a bond to be Rs. 1,000 and its coupon rate at 10%. Then, the fixed interest amount is 10% of Rs. 1,000 i.e. Rs. 100. Now, suppose the price of the bond has decreased to Rs. 980, then the current yield from the bond is Rs. 100 divided by Rs. 980, i.e. 10.20%. Similarly, if the bond price increases to say, Rs. 1,100, the bond yield will decrease to 100/1100 i.e. 9.09%.
Yield To Maturity (YTM) of a debt fund refers to the rate of return that an investor can expect if he/she remains invested in the fund until its maturity. The YTM of a debt fund may change from time to time as a result of changing market and economic conditions.
- Modified Duration:
Modified duration of a debt fund indicates the sensitivity of its value to the changes in interest rate. There exists an inverse relationship between bond prices and interest rates. Thus, the bond prices decrease in response to an upward movement in interest rates and increase when interest rates decrease.
For instance, if the modified duration of a debt fund is 2 years, then a 1% increase in interest rates will result in a 2% decrease in the value of the fund. The higher the modified duration of a debt fund, the higher its sensitivity to market interest rates.
Here is a List of top Performing Debt Funds to Invest in FY 2020-21