How do you choose the most suitable fixed income fund? There are many types of fixed income funds such as liquid and ultra short-term funds, pure income funds and dynamic bond funds. You have to assess three main requirements—liquidity, risk and credit quality—to choose the appropriate fund. Returns in a bond fund are commensurate to the combination of the above factors.
Liquidity basically refers to the ease with which you can move in and out of a fund or any investment product at low transaction costs. In case of fixed income funds, in order to prevent sudden large outflows which can impact portfolio returns, exit loads are applied if you withdraw before a certain period of time. Liquid funds and overnight funds are typically meant for very short-term investments—from 1 day to a week or two. Hence, these funds don’t usually have an exit load.
Ultra short-term funds also aim at facilitating short-term parking of money but cater to investors, who have some idea on when they may need the money. Typically, here you may find exit loads from a period of 15 days to 90 days and in some cases even 180 days. Short-term income funds and pure bond funds are investment products rather than tools for parking idle cash. Here exit loads can be up to 6 months, a year or even more.
The more liquidity-oriented the fund is, the lower would be the exit load. Choose a fund based on how long you need to stay invested.
Fixed-income securities come with a specified coupon or rate of interest payable at maturity. The price of debt securities and bonds increases if interest rates fall and vice-versa.
This risk of how sensitive the price of the securities in a fixed-income portfolio are to change in interest rates is measured by a concept called duration. Duration is measured in years and the longer it is, the more sensitive the portfolio is to a small change in rates. Most funds declare the duration of a portfolio in the monthly factsheet—calculating it can be complex for you. Generally speaking, in a rising rate environment, it is better to have a low duration fixed income fund and in a falling rate environment, high duration can potentially give you high returns. Typically, funds meant for short-term parking of money have low duration and pure bond funds meant for investment have high duration.
You need to now whether the securities held in your fixed income fund are of investment grade or not. Fixed income securities are typically rated on quality (probability of default of financial obligations) by a licensed credit rating agency. This is reflected as AAA or AA or equivalent rating and has to be disclosed by the mutual fund. If you are not a high risk taker, then ensure that 80-90% of the portfolio is in the highest rated securities. Lower rated securities create demand by offering a higher interest, but returns shouldn’t come at the cost of quality. Make sure your fund has a balance of both.