How to choose the right debt fund? Here are the key steps

As opposed to the misconception of debt funds being entirely safe, these funds are subject to both interest rate risk and credit rate risk that investors must be aware of.

Abeer Ray, MintGenie Team
First Published3 Mar 2023, 08:15 AM IST
Debt funds are also subject to risks.
Debt funds are also subject to risks.(Pixabay)

So many mutual fund houses are now coming up with new debt fund instruments that have prompted many invested to think if they are worth any good. To top it all, debt fund instruments do not yield too high returns and have done little good to people, except those who parked their money for the short term and benefited from the liquidity and mediocre returns that the funds offered. One common bug that bites them all is how to choose the best debt mutual fund. This is not surprising as many debt fund houses defaulted on their investors’ money in 2019. 

Do debt funds contain risk?

Do not underestimate the risk in a debt fund because it boasts of putting your money in secured and government bonds. There is an inherent risk associated with these funds that people either ignore or fail to realize. 

Viral Bhatt, Founder, Money Mantra said, “Debt funds are mutual funds that invest primarily in fixed-income securities such as bonds, treasury bills, and other debt instruments. While debt funds are generally considered to be less risky than equity funds, there are still risks associated with investing in them. Some of the common risks associated with debt fund investments include Credit risk, interest rate risk, liquidity risk- and inflation risk.”

Bhatt added, “Credit risk is the risk of default by the issuer of the debt instrument. If the issuer defaults on its payments, the value of the debt fund may decline. However, debt funds are also affected by changes in interest rates. If interest rates rise, the value of the debt fund may decline. Conversely, if interest rates fall, the value of the debt fund may rise. Investors may also be affected by liquidity risk when the debt instrument may not be easily traded in the market, making it difficult for the fund to sell its holdings when it needs to. One cannot ignore the impact of inflation on debt funds’ performance as these funds are subject to inflation risk, which refers to the risk that the returns from the fund may not keep pace with inflation, resulting in a decline.”

Knowing the kind and extent of risk involved in debt fund investing is important before you venture out to put your money into any. This also means that before you invest in a debt fund of your choice, you must check the quantum of risk you are willing to take. 

At a time when interest rates are going up, many investors complain how the bond yields are also falling with time. What they fail to see is that the bond prices go up in equal tandem with the repo rate hikes, thus, resulting in rising net asset values (NAVs) of the debt funds.

Know your investment tenure

Many investors also want to know about how long they must stay invested in these funds. This is because investors holding long-duration bonds are prone to facing credit rate risk. This is a serious issue as this kind of risk can result in permanent loss of capital. 

While investing in debt fund instruments, how do investors avert being subject to credit rate risk? Suresh Sadagopan, MD & Principal Officer, Ladder7 Wealth Planners said, “Many of the debt funds clearly have the mandate to invest in high-quality papers. One could also look at the portfolio to understand where they are investing. Also, there are certain categories like banking and PSU debt funds and funds investing in Gilt funds, SDLs, and PSU debt where the underlying papers are of high quality. One could choose these if one may want to invest in funds that invest in high credit papers.”

This also means that you must avoid putting your money into funds that invest in weaker companies having a lower credit rating below AA, thereby, taking a higher risk to earn more returns. Read the Scheme Information Document carefully to check the allocation of the fund into banking and PSU funds compared to corporate debt funds. 

Investment horizon matters as long-term bonds are subject to all kinds of risks prompting many analysts to choose funds with a lower investment tenure or those with maturity periods lesser than one’s investment tenure. 

These and many such factors must be considered while deciding between the available debt fund investments or whether to invest in debt funds at all. Many investors look at past year returns not realizing how the past performance is not an indicator of future fund performance. Debt fund returns vary and are always subject to change, which is why one must be aware of myriad conditions before deciding when and how much money to invest. 

Short term debt funds
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First Published:3 Mar 2023, 08:15 AM IST
HomeMoneyPersonal FinanceHow to choose the right debt fund? Here are the key steps

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