Mutual Fund – Kaun Sa Sahi Hai? How to Choose a Debt Fund

In my last blog, I had mentioned about the things to keep in my mind while investing in equity funds. In case you haven’t read that yet, it is available here. In this, I will tell you how to choose a right debt fund.

Most often, when we come across mutual funds, the only things that comes to your mind is save tax and invest in equities for a really long period of time. But this is just one small part of the mutual fund industry. What is often missed is the larger space of investing possibilities in debt funds.

Most agents do not want to sell a debt fund as the commissions are low and the expertise required to understand them is high. Banks never

recommend investing in it as money in your savings account or fixed deposits will be more profitable for them. Most investors perceive these to be low-return yielding funds and hence do not fit in their ‘definition’ of mutual funds.

In the following sections, I will bust some of the myths associated with debt funds and follow it up with ways to identify a good debt fund to invest.

Myth 1: Debt funds equals liquid funds

The only debt fund most of you are aware of are liquid funds. Liquid funds have gained popularity in the recent past due to a lot of advertisement as an option to keeping money in savings bank. But, the world of debt funds begins with liquid funds and has many more types – Short Term Funds, Income Funds, Gilt Funds, Dynamic Funds, Credit Funds, Fixed Maturity Plans etc. Confused? Do not worry about what these mean. They have been explained here. So yes, debt funds have many more options than equity funds.

Myth 2: Debt Funds yield low returns

Would you believe me that debt funds can give more returns than equity? Would you believe me if I said debt funds have given returns in the range of 18% – 23% in the recent past? Absolutely not. But it is true. There have been instances where debt funds have given phenomenally high returns – the latest being 2016-17 where funds did see returns around 20% p.a. I am not implying that this kind of returns would be possible at all times. Currently, on an average, debt fund returns vary from approx. 6% p,a to around 10% p.a depending on the type of fund. Comparing to other fixed return investments, the returns are fairly higher.

Myth 3: Debt Funds are risk free

It is commonly believed that debt funds are risk-free. While it is true that they are not as volatile as equity, to consider them risk-free would be a folly. Debt funds carry two risks – credit risk and interest rate risk. Let us quickly understand each of these:

Credit Risk: Let me ask you a simple question – what would have happened if you had given a loan to Vijay Mallya (or Nirav Modi)? The answer is obvious – you would have lost your money. This is credit risk – the risk of losing either a part or full amount that you have given as a loan. If the fund manager invests in a company that goes bankrupt, your money is lost.

Interest Rate Risk: Let me again ask you a question – you bought a mobile phone by paying Rs. 35000 and the next day the company reduced the price to Rs. 30000. Will your phone now get lesser value if you try to sell it as compared to the price that you would have got had the company not reduced the price? The answer is yes – because the new product is available at lower price now. Similarly, let us say your money is invested in a debenture that pays an interest of 8% p.a. In the next few weeks, the rates in the markets have increased for whatever reason and now similar debenture is paying an interest of 9% p.a. If you want to sell your debenture, you will get a lower price as your debenture earns 1% lower than the other debentures. This resulting loss is due to interest rate risk.

Now that we are aware of some of the myths, let us look at simple ways to choose a good debt fund.

Match Risk Tolerance with Credit Profile of the fund

As explained above, different debt funds carry different level of risk. Match your risk tolerance with the credit profile of the fund. You can get a fair idea about the risk associated with the fund by looking at the Portfolio Classification by Asset Class as well as by Rating Class. A sample of this classification can be seen below. Typically, they are arranged by starting with lower risk and moving to higher risk (cash always at end as an exception).

Match Time Horizon with Fund Type

By now you are aware that debt funds are not only for investing for a few days. The time frame of your investment would decide the type of fund that you should invest in. The below table provides you with reference points to decide on the right debt fund for you.

Time Horizon Type of Debt Fund
1 day – 3 months Liquid Funds
3 months – 1.5 years Ultra Short-Term / Short-Term Funds
1.5 years – 3 years Short Term Gilt
3 years – 5 years Dynamic Bond Funds / Credit Opportunities Funds / Long-Term Gilt
3 months – 3 years Fixed Maturity Plans

Watch the interest rate scenario

We cheer whenever RBI reduces interest rates as we expect our home loan EMI to reduce too. If you invest in debt funds, you will have another reason to cheer. Whenever, RBI reduces interest rate the value of your existing fund increases (as explained above with the example of mobile phone). On the other side, whenever RBI increases interest rate, debt funds will underperform. Hence it is important to have a fair idea of the interest rate scenario that RBI is following.

Another thing to remember is the longer the average maturity of the fund, the more sensitive it will be to any change in interest rate. This is because if you are holding a debenture with longer maturity, you will be earning less for a longer period of time. So, if you are a risk averse investor, invest in a debt fund which has lower average maturity and lower modified duration. If you want to know more about modified duration, click here.

With these three things in mind, you can invest any surplus that you have in your bank in a debt fund and enjoy extra returns without affecting your payment plans. All you need is an online investment account and you can invest and withdraw at ease and the money gets credited to your bank account within 24 hours. So, don’t let the money idle in your bank even for an extra day and loose on an opportunity to make your money work for you. If you want to know how to make your money work for you and create an online account for the same, click here.

Posted by Alok Chhajer

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