Debt Funds: An Introduction
Debt funds are mutual funds that invest in fixed-income generating securities such as government securities, corporate bonds, commercial papers, treasury bills, etc. The main reason for investing in these funds is to gain capital appreciation along with interest. The issuer of debt funds decides the rate of interest that you will get at the time of maturity.
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Different Types of Debt Funds
Fund houses have come up with different types of debt funds to cater to the diverse needs of investors and their financial goals. The primary factor of differentiation between debt funds is the maturity period. Here are the different types of debt funds:
- Dynamic Bond Funds
- Income Funds
- Liquid Funds or Money Market Funds
- Short-term and Ultra Short-term Funds
- Gilt Funds
- Credit Opportunities Funds
- Fixed Maturity Plans/Funds
What are Long Term Debt Funds?
Some of the aforementioned funds are classified as long-duration debt funds because their average maturity is more than 36 months. Long duration debt funds are a good investment option because of lower risk as compared to equity, moderate returns and efficient tax treatment due to indexation benefits. These funds are preferred by investors with a longer investment horizon.
However, individuals with a low-risk appetite should stay away from long duration debt funds as they are riskier as compared to short term debt funds because of market fluctuations.
Some of the dynamically managed long-term debt funds are explained below:
Income Funds: These funds primarily aim at generating regular income by investing the corpus in government bonds, corporate bonds, certificate of deposits, and other debt instruments. These funds are highly vulnerable to market changes in terms of interest rates. However, Income funds try to deliver returns even when the market is volatile and interest rates are not stable, by actively managing the portfolio.
Therefore, the income debt funds are suitable for those who have a long-term investment horizon and high risk-bearing capability. To make the most out of income funds investment, it is advisable to plan your entry and exit properly. One should enter when the interest rates are low and exit when the interest rates start rising.
Gilt Funds: These funds only invest in government securities of the central and state governments with long and medium maturity period, i.e. basically in high-rated securities with low credit risk. Low credit risk is because the government rarely defaults on the loans it takes from the public through the issuance of debt securities. This makes these funds ideal for risk-averse fixed-income investors.
Dynamic Bond Funds: As the name suggests, these funds comprises of the portfolio which is dynamic in terms of composition and different maturity period. Fund managers keep on changing the portfolio composition as per the changing interest rate regime. These funds usually have a huge number of assets under management having a valuation of several thousand crore.
These funds have fluctuating average maturity duration as they take the interest rate calls and invest in instruments of small as well as long maturities.
How to Invest in Long-Term Debt Funds?
One can invest either through regular contributions (known as the Systematic Investment Plan (SIP) or as a lump sum. For smaller investors, SIP is the most viable option.
Nowadays, with the wave of digitisation, there is a lot less paperwork involved while investing. The process is hassle-free and one can start investing from the comfort of their home.
Also Read: Best SIP to Invest in 2020
How to Choose the Best Debt Funds?
The suitability of debt funds more or less relies on the risk appetite of an individual. For instance, gilt funds are less volatile than income debt funds. They are suitable for those investors who are uncomfortable with heavy portfolio fluctuations.
Long-term funds provide investors with the best opportunities when interest rates fall. It is important to keep a fairly long horizon along with systematic investment to reap maximum benefits.
How to Evaluate the Best Debt Funds?
Debt mutual funds are somewhat neglected by investors due to lack of knowledge and understanding of these investment products. However, this investment category provides ample opportunities to earn decent returns in the fixed-income space.
There are several qualitative and quantitative parameters to determine the best debt funds as per the precise needs of an investor. In addition to this, an investor must keep their financial objectives, risk appetite and investment horizon in mind to find the right debt fund for investment.
Investors should consider the following points for evaluating long-term debt funds:
- Fund History: Always choose a fund house that has a strong and stable history of consistent market performance in the investment domain. Consider the track record of the last 5-10 years to choose the right debt fund.
- Fund Returns: An investor needs to look for consistent returns over a long-term of say 3-10 years. Select funds that have outperformed their peer funds and crossed the benchmark rate of return across different time frames.
However, do not forget to analyse the fund’s performance with your investment horizon to get the best results.
- Expense Ratio: Expense ratio shows how much of your invested amount is going into managing several expenses of the debt fund. A high expense ratio decreases the Net Asset Value (NAV), which further reduces your returns. A lower expense ratio means higher returns. It is advisable to choose a fund with a low expense ratio to get better returns.
- Financial Ratios: An investor can use financial ratios such as standard deviation, Sharpe ratio, alpha and beta to analyse a debt fund. A fund with a high standard deviation and beta are usually risky. Always look for debt funds with a higher Sharpe ratio. Higher the Sharpe ratio, the better the risk-adjusted return of the portfolio.
Also Read: Best Debt Fund to Invest in 2020