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Business News/ Money / Personal Finance/  6 aspects to consider before investing in debt funds

6 aspects to consider before investing in debt funds

Planning to invest in debt funds? But before that one should be clear of the misconceptions that debt funds are safe. All mutual funds carry risks and debt funds are no exception. Let's discuss the aspects one should look at before investing in these funds.

Before investing in debt funds, you must know the various elements you need to analyse.

To make informed investment decisions, check the critical metrics for evaluating debt funds, including AUM, average duration, YTM, modified duration, and credit rating.

Looking to invest in a debt fund? Before investing in debt funds, you must know the various elements you need to analyse.

But first, it is essential to remove the misconception that debt funds are safe. All mutual funds, including debt funds, carry risk.

Here are some of the aspects that you need to look at before investing in a debt fund:

Investment objective: The first thing you need to do is understand the fund’s objective. Debt funds also invest in different securities, such as government bonds, treasury bills and corporate bonds, and these investment securities come with their characteristics. As a result, the investment objective of the fund will also vary. Some debt funds are meant for goals 3 years away, and some for less than one year. So, before you invest in debt funds, it is vital to understand the objective of the fund and whether the fund suits your financial goal.

Average maturity: The best way to understand if the debt fund aligns with your financial goal is to check the fund’s average maturity. Debt fund managers can invest in debt papers whose maturity might range from one end of the spectrum to another. The average maturity is the weighted average of the maturity period of all the current securities in the fund.

For instance, the average maturity of ICICI Prudential Ultra Short Term Fund is 0.46 years. So, this fund will fit investors looking to park their money for three months or more.

However, it is important to understand that the underlying securities will mature, not the fund.

Macaulay Duration: Another parameter to help you select the right debt fund is the Macaulay Duration. It shows the average time it will take for investors to receive payments from their debt instruments to match the amount that was paid for the debt paper.

The Macaulay duration is generally mentioned with the scheme’s objective to help investors invest in the right debt fund. For example, if the fund mentions that its Macaulay duration is between three months and six months, it is meant for investors whose investment horizon is between three to six months.

Modified duration: Debt funds are impacted by interest rates. Debt funds underperform when the interest rate goes up and vice versa. This parameter indicates how sensitive the fund is to interest rate changes. A higher modified duration means interest rate changes will greatly impact the fund.

Returns: Once we determine that the fund matches our investment horizon, we need to check the fund’s past returns. It is important to understand that past returns don’t guarantee future returns but merely act as an indicator and show how the fund has performed during the various market cycles.

You can check the fund’s returns for different time frames, such as 1-year, 3-year and 5-year, against its benchmarks and peers. If the fund has beaten the benchmark and has performed better than the category average, then we can assume that the fund has performed well.

Yield to Maturity (YTM): Want an idea of what your debt fund might earn? You can look at the fund’s YTM. It estimates what the fund might earn if the fund manager holds all the current investments till maturity. However, the YTM will keep changing as the fund manager will buy and sell debt papers.

You can find the YTM on various mutual fund research websites. Compare the YTM of the fund with the category average. If the YTM of the fund is greater than the category average, then the fund can be a good fund.

Rating of the papers: In addition to interest rate risk, debt funds are susceptible to credit risk. Companies get credit ratings just like we have credit scores for our creditworthiness, i.e., the likelihood of repaying the loan interest and principal. AAA is the highest rated credit rating. Companies with an AAA rating have the highest probability of honouring their debt obligations. Because of this, the interest rate on these papers is lower than other papers. When analysing debt funds, you must consider whether the fund is taking excessive credit risk for higher returns.

Assets Under Management (AUM): AUM is the total assets managed by the fund. It is the current investment value of all the investors. This aspect might seem like a vanity metric. However, it is always recommended that retail investors like you and me invest in debt funds with large AUM. It is because you will be protected from large-scale redemption pressures. If the fund size is small, the fund house might have to sell high-quality debt papers to honour the redemption requests. This impacts the returns generated by the fund.

Moreover, a large fund manager can negotiate for better interest rates than a fund with a low AUM.

Padmaja Choudhury is a freelance financial content writer. With around six years of total experience, mutual funds and personal finance are her focus areas.

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