With 16 debt fund categories and over 320 schemes to choose from, selecting the right fund can be a daunting task for many retail investors. A wrong fund selection can increase the risk of generating sub-optimal returns or, worse, capital erosion. Investors must consider the following factors when investing in debt funds.
Choose an optimum debt fund category
Average maturity and modified duration
The average maturity of a debt fund is the weighted average of all current maturities of debt securities held by it, while the modified duration of a debt fund refers to its sensitivity to the changes in policy rates or other broader market interest rates. Debt funds having higher average maturity and modified duration have a higher sensitivity to interest rate changes, which allows them to perform better during a falling interest rate regime. Debt funds with lower modified duration and average maturities perform better during rising interest rate regimes.
The expense ratio of funds refers to the proportion of their overall assets utilized for meeting overall expenses. The importance of expense ratio as a selection parameter for debt funds increases, particularly for those belonging to ultra-short, liquid, and low duration fund categories as they have restricted upside potential compared to equity funds. Hence, choose direct plans of debt funds as they have a lower expense ratio than regular plans.
Yield to maturity (YTM)
The yield to maturity (YTM) of a debt fund refers to the weighted average yield of its portfolio constituents. It provides a fair idea about the interest income that a fund can accrue if all its portfolio constituents are held till their maturities. Debt funds investing in fixed income instruments having higher coupon rates contain higher YTM than others. However, YTM cannot be the only indicator of potential gains from debt funds as their actual returns depend on the changes in their mark-to-market valuations and portfolio. Hence, factor in the net YTM of fund portfolios, which actually is the gross YTM minus expense ratio.
Debt funds mention credit ratings of the underlying portfolio constituent in their fact sheet. Such ratings indicate the creditworthiness of the issuers of securities. For example, instruments having a credit rating of AAA contain the lowest credit risk whereas those with a ‘C’ credit ratings are considered to have high default risk. A review of the fund fact sheet will provide you a fair idea about the credit risk exposure of debt funds and their compatibility with your risk appetite. As instruments having lower credit ratings contain the potential to generate higher returns, reviewing the fund’s portfolio constituents will even assist you to gauge the fund’s upside potential.
Current interest rate regime
The market price of existing fixed income securities increases during the falling interest rate regime as their coupon rates are likely to be more than the ones offered by the freshly issued debt securities of similarly rated issuers. However, in the case of a rising interest rate regime, existing fixed securities prices fall as the investors prefer investing in newly issued securities providing higher coupon rates as compared to the older ones. As a result, debt mutual funds generate higher capital appreciation during the falling interest rate regime and vice versa.