How to choose a debt fund?
Debt funds are not as risky as equity funds but offer higher effective returns than fixed deposits, here is a list of things to consider before you invest.
Unlike equity, for which you need to be invested over long period of time, debt funds have different maturities.
If you need to be invested for only a couple of months then you should look at Liquid funds or Ultra-short Term funds. If your investment horizon ranges from one to three years then there are Short-Term funds or Income funds that you could look at. For longer periods you have Intermediate and Long-term debt funds. You can also opt for Fixed Maturity Plans if your investment horizon is defined, though these come with a lock-in.
Credit Rating of the Fund
Don’t blindly opt for a fund that has been giving exceptional returns. Look at the fund’s portfolio to see why they have been giving such good returns and whether this will continue. Every debt fund is assigned a credit rating. A high rating basically means the fund has a lower chance of defaulting.
Factor in interest rate risk
It is a popular myth that debt funds don’t carry any risk. They do have their share of risk, although they are not as perilous as equity funds. The biggest factor affecting debt funds is interest rate risk. That’s because bond prices fall as interest rates rise and vice versa.
Consider a scenario in which benchmark bank rates are expected to move upwards. Let’s say that Bond A is issued with yield of 7 % and a maturity of 15 years.
Bond B is issued with yield of 8 % and maturity of 10 years. In a rising rate scenario, Bond A will become less attractive in future and its price will start falling.
Debts funds with a longer maturity are at a higher risk when interest rates are rising. During such a period, go for a debt fund with lower maturity.
And when the interest rates are falling opt, for funds with higher maturities.
Credit risk of the company
Credit risk essentially means the credit worthiness of the issuer of the debt fund. It tells you if the bond issuer is able to pay the interest on time and repay the principal on maturity.
A firm with a low credit rating often tries to lure investors by offering a higher return. So if the fund is giving fabulous returns, the first thing you must check is what kind of instruments and assets the fund is investing in. Among the safest instruments to invest in are Government bonds, and funds that have a greater exposure to them are thereby the safest.
Poor assets have very low demand. A fund with a high exposure to such assets could potentially face a liquidity crunch if the fund manager is unable to sell them. So it is best to steer clear from such funds.
Beware of the costs involved
Since debt funds normally give a lower return than equity funds, the costs can eat into a sizable chunk of your earnings. Look at the expense ratio and the exit loads of the funds. In order to discourage early redemptions many funds levy an exit load. So keep this in mind when investing in debt funds.
Size of the Fund
The size of a debt fund is pretty significant. This is due to the fact that trading in the debt market needs large investments. A large fund also ensures that the debt manager will be able to comfortably meet redemptions without resorting to distress sales.