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A debt fund is one where income is generated by way of making investments in government bonds, commercial papers, corporate bonds, treasury bills, and various money market instruments. When it comes to making a choice, the range of debt funds is vast; for instance, there are gilt funds, liquid funds, money market debt funds, and the like. So, how can an investor select the debt fund best suited to his needs and requirements? There are a few aspects that must be considered whilst choosing a debt fund. Let’s have a look at them.
1. Risk Tolerance and Investment Horizon
An investor must be clear of their risk tolerance levels and investment horizon before making a choice. Based on this, one can select the debt fund and also decide on the time period of staying invested in it, and the expected returns from the investment. In order to be clear on these aspects, as an investor, you must be well aware of the variety of debt funds that are available for investment.
For instance, if the aim is to place funds for emergencies, then one could opt for a Liquid Fund or Overnight Fund. Selecting a Long-term Fund would be a bad choice if the investor’s time horizon for investment is just 2 months.
2. Understanding the Types
A Debt fund has been considered to be not as risky as an equity fund. However, note that there are different types of debt funds that come with different levels of risks and also different investment periods. So, an investor must be very clear of the particular debt fund that they intend to invest in. Let’s look into the different types of debt funds.
- Liquid funds: They invest in debt/money market instruments and have a maturity of about 91 days.
- Dynamic Bond Fund: They invest in debt instruments having different maturities, the basis of investment being the interest rate policies. Investors who want to stay invested for 3-5 years and look for moderate-risk investment can opt for this.
- Money Market Fund: They invest in money market instruments having a 1-year maturity (maximum). Investors looking for debt securities having low risk and wishing to stay invested for a short period could opt for it.
- Corporate Bond Fund: They invest about 80% of their total assets in those corporate bonds that have high ratings and investors having a low-risk tolerance can invest in these bonds.
- Gilt Fund: They invest around 80% of their investible corpus in funds that are free from credit risk, for instance, government securities of different maturities. However, note that there is a high-interest rate risk.
- Banking & Public Sector Undertakings (PSU) Fund: This fund invests about 80 of the total assets in PSU as well as debt securities.
- Floater Fund: This fund invests around 65% of the investible corpus in instruments of low-interest rate risk and that have a floating rate.
- Credit Risk Fund: These funds invest about 65% of their investible corpus whose ratings are below that of corporate bonds of the highest quality. They come with a bit of credit risk, however, they provide slightly better returns in contrast to bonds of the highest quality.
- Ultra-Short Duration Fund: These funds invest in debt securities as well as money market instruments, wherein the schemes Macaulay duration lies between 3-6 months.
- Overnight Fund: These funds invest in those debt securities that come with a 1-day maturity period. They are quite safe as credit risk as well as interest rate risk are negligible.
- Low Duration Fund: These funds invest in debt securities as well as money market instruments, wherein the schemes Macaulay duration lies between 6-12 months.
- Short Duration Fund: These funds invest in debt securities as well as money market instruments, wherein the schemes Macaulay duration lies between 1-3 years.
- Medium Duration Fund: These funds invest in debt securities as well as money market instruments, wherein the schemes Macaulay duration lies between 3-4 years.
- Medium to Long Duration Fund: These funds invest in debt securities as well as money market instruments, wherein the schemes Macaulay duration lies between 4-7 years.
- Long Duration Fund: These funds invest in debt securities as well as money market instruments, wherein the schemes Macaulay duration exceeds 7 years.
3. Risk-Return Expectations
When selecting a debt fund, always be very clear of your risk-return expectations from the fund. Debt funds come with 3 types of risk:
- Credit Risk: This refers to the risk associated when the issuer defaults in repaying the principal as well as interest.
- Interest Rate Risk: It refers to the impact that changes in interest rates have on the scheme’s securities valuation.
- Liquidity Risk: This refers to the lack of liquidity of the fund house in meeting the redemption requests of investors.
A rise in interest rates could impact long-term funds negatively thereby giving lesser returns and vice versa. Similarly, a credit upgrade positively impacts the credit risk funds and vice versa. Those investors who are looking out for a steady income and have low-risk tolerance can opt for shorter maturity funds having a low credit risk portfolio.
4. Track Record
It is in the best interest of the investor to study the track record of funds and check their performance across the market cycles of credit/ interest rates.
5. Diversification
Always opt for a fund that has a portfolio that is well-diversified as it acts as a cushion to any negative impact caused by any of the securities.
6. Expert Advice
In order to understand all about investment and how to invest in any type of financial instrument, the best way is to consult with a financial advisor who can map your goals to the investment strategies and place the right debt fund before you. An advisor would also help in monitoring the performance of your investments and would help you make necessary changes to your portfolio, as and when required. To sum it up, while selecting any debt fund as an investment option, an investor needs to bear in mind the time horizon of investment, his/her risk tolerance levels, and liquidity requirements. When in doubt, always head to a financial expert for guidance!
