Home / Money / How to pick a debt fund that fits your needs

It’s is known that when you invest in an equity fund, you need to put away your money for at least three years. At least that is what we recommend, though longer the tenure the better. As far as your investment horizon is concerned, it doesn’t really matter which equity fund you are investing in—only mid-cap funds command a longer horizon. But debt funds are different.

Debt funds are meant, among other things, for short-duration investments—one month, six months, a year and so on. So, how do you decide which one is for you? And should you match your duration with that of the fund to ensure you buy the right fit?

Rates and prices are inversely related

To pick the right debt fund, it’s important to understand how they work and what differentiates one from the other. Just like the prices of your equity scrips move up and down depending on a host of factors, such as the company’s prospects and market sentiment, the prices of debt scrips also fluctuate. This fluctuation largely depends on the demand or supply of money being borrowed or lent, besides the movement in interest rates.

Interest rates and prices of debt securities move in opposite directions. When interest rates rise, the prices of debt securities fall, and vice-versa. Here’s why. Say, a company issues a debt instrument in the market that fetches its holder an interest rate of 8%. A few months later if the interest rates in the economy go up, there will be newer debt instruments that would offer a higher interest rate, say, 9%. These new instruments would fetch a higher return than the 8% interest instrument. The value (market price) of the older paper—and also the net asset value (NAV) of your debt fund that has invested in these papers—also goes down.

Also See | The Right Match (Graphic)

For instance, when the price of the 10-year government security fell from a high of 9.47% as on 11 July 2008 to 5.25% on 1 January 2009, long- and medium-term bond funds returned 35.04%. Similarly, when interest rates rose from 6.51% to 8.37% between February 2005 and July 2006, these funds returned 4.42%.

Matching time horizon

The investment horizon of the fund and the calls that the fund manger takes on the direction and timing of interest rates will all have a bearing on your return. The first thing you need to do is to find a fund that has a time horizon that meets your’s. To get the most out of your debt funds, match your investment horizon with that of the debt fund.

Your debt fund may be the best long-term bond fund, but if you invest in it for a period of, say, two months, you could end up with a loss if long-term interest rates get volatile in this period. Similarly, it doesn’t pay to stay invested in a liquid fund for, say, two years as your returns will be modest.

A good measure to look at your fund’s sensitivity to interest rates is its modified duration. Most fund houses disclose this in their monthly fact sheets. Expressed in years, this number will tell you how much your debt fund would get affected if interest rates (your bond fund’s yield) were to move up or down by 1%.

Assume your bond fund has invested in a 10-year bond with a face value of Rs100 and a coupon (interest rate) of 8%. Back of the envelope calculations show that the yield to maturity of this bond comes to 8.16% and the fund’s modified duration comes to 6.77 years. In simple words, it means that if your fund’s yield rises by 1%, the bond price will fall by Rs6.77. Or, if the fund’s yield falls by 1%, the bond price will rise by Rs6.77. Higher the modified duration, the riskier is your fund because its impact on change of interest rates will be high. Typically, long-term bond funds have a higher modified duration and vice-versa.

Which category to choose

There are 10 categories in the debt fund space, ranging from liquid, ultra short-term, floating to long-term and short-term monthly income plans. Five of these are meant for investments up to a year. So, how do you sort out the clutter.

“There are just too many categories. Even mutual funds’ sales and marketing people do not understand the nuances, how will the agent or the investor understand," wonders Nilesh Shah, deputy managing director, ICICI Prudential Asset Management Co. Ltd. Shah believes it is time for fund houses to consolidate their numerous debt funds to offer the bare minimum choices to investors, devoid of the clutter.

We suggest you consider only four categories of debt funds. Ultra short-term funds, short-term bond funds, long-term bond funds and monthly income plans. While liquid funds work well if you wish to park your cash for about a week to a month, the tax advantage is marginal and doesn’t merit taking additional risk. “Go for ultra short-term funds if you wish to park your money for three to six months," says Shobit Gupta, head (fixed income), Principal PNB Asset Management Co. Pvt. Ltd. For investment between three months and 12 months, short-term bond fund is a good option. “If you wish to invest for a period of three years or more, go for long-term bond funds," adds Alok Singh, head (fixed income), Fortis Investment Management (India) Pvt. Ltd.

Similarly, some funds have more than one options within the same space. For instance, as per Morningstar India’s classification, Deutsche Asset Management Co. Ltd has four options in the ultra short-term space, apart from one liquid fund. Morningstar India classifies funds as per their last three years’ portfolio. IDFC Asset Management Co. Ltd has two ultra short-term funds. Shah says: “Typically, go by size and pick the larger one. Size is critical for debt funds as small-sized funds do not withstand high levels of volatility in the debt market. Besides, all funds pay more attention to a flagship fund."

Does lock-in make sense?

In October 2008, debt funds sank on the back of panic redemptions. Apart from the capital market regulator, the Securities and Exchange Board of India, issuing several guidelines restricting the risks that debt funds take, some mutual funds started imposing exit loads on debt funds with shorter tenures, especially ultra short-term funds.

Exit loads also ensure that investors avoid coming to ultra short-term funds due to the tax advantage that they have over liquid funds and make quick exits. Large-sized withdrawals can force the fund manager to sell liquid scrips at throwaway prices, thereby hurting existing investors. “Having a lock-in also helps the fund manager as it helps him manage the scheme’s inflows and outflows better. It leaves lesser amount of idle cash," says Suresh Soni, chief executive officer, Deutsche AMC.

Graphic by Yogesh Kumar/Mint

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