How to Choose the Right Debt Fund For Your Portfolio?
Debt funds generate income by investing in fixed-income securities, government, and corporate bonds, treasury bills, commercial paper, certificates of deposit, and other money market instruments. Though debt funds are less risky than equity funds, they must be chosen wisely to generate good returns.
Here’s how you can pick the right debt fund for your portfolio:
Understand Your Investment Horizon and Risk Appetite
Before understanding where to invest, an individual should first understand his/her personal investment goals, i.e., when the funds will be needed and his / her risk-taking capacity.
On the basis of these parameters, you can decide which debt fund to invest in for how long when you need that investment, and what are your return expectations. This is where knowing the different types of debt funds comes into play.
Know About the Different Types Of Debt Funds
Even though debt funds are less risky than equity funds, the subcategories of debt funds have varying risk levels and investment duration. Hence just knowing that you want to allocate a certain sum of money to debt funds will not suffice. You also need to look at the different types of debt funds available.
For example, credit risk funds are considered riskier than liquid funds under the same debt fund category. Because of such differences, you must know about the different types of debt funds available.
Debt funds invest in bonds issued by companies and governments, which may either be categorized based on maturity tenure or the nature of the bond.
Here are the different types of debt funds as categorized by the Securities and Exchange Board of India.
| Debt Funds | Underlying Security |
| Overnight Funds | Overnight securities with a maturity of 1 day |
| Liquid Funds | Debt and money market securities with maturity of up to 91 days |
| Ultra-short Duration Funds | Investment in debt and money market instruments with a Macaulay duration between 3 and 6 months |
| Short Duration Funds | Investment in debt and money market instruments with a Macaulay duration between 1 and 3 years |
| Long Duration Funds | Investment in Debt & Money Market Instruments with a Macaulay duration of more than 7 years |
| Dynamic Bond Fund | Investing across duration |
| Credit Risk Funds | 65% minimum investment in corporate bonds – (investment in low-rated instruments) |
| Gilt Fund | 80% minimum investment in government securities (across maturity) |
| Banking and PSU Funds | 80% minimum investment in debt
instruments of banks, public sector undertakings, public financial institutions |
| Corporate Bond Funds | 80% minimum investment in corporate bonds (only in highest rated instruments) |
| This is not an exhaustive list of debt fund categories. This is also not a recommendation that one should invest in only these debt funds. Please research well before investing. | |
Read More on Groww: Debt Funds
| Quick Take: What is Macaulay Duration?
Macaulay duration is a measure of how long it takes for the price of a bond to be repaid by its internal cash flows. It is used only for a debt instrument with fixed cash flows. |
Know About The Nature Of Different Debt Funds
Debt funds are considered less risky than equity funds. Amongst the debt funds, liquid funds have a very low risk, while Gilt Funds & Bond/Income Funds are riskier. Further, investors should also consider the credit rating given by credit rating agencies – which ranges from AAA+ to D, with AAA+ being the highest.
In simple words, a fund with a higher rating is safer than a fund with a lower rating. Funds with lower ratings tend to offer higher interest rates. Risk and returns go in opposite directions. While a high returning instrument will be risky, a low returning one mostly has a moderate risk profile.
Hence, it is essential to keep in mind your risk appetite before investing in a debt fund.
Beware Of Risks Involved in Investing In a Debt Fund
There are 2 significant risks involved while investing in a debt mutual fund – interest rate risk and credit risk.
Interest rate risk is the risk of fluctuation of the interest rate. Interest rate and Net Asset Value (NAV) are inversely related, i.e., if the interest rate increases, NAV falls and vice versa. The interest rate risk mostly does not impact the immediate short-term funds but impacts the NAV of long-duration funds.
Credit risk is the risk that the fund may not pay on time. Credit rating agencies like CRISIL and ICRA give ratings to mutual funds. Credit ratings keep on changing from time to time.
For example, if the fund holds papers downgraded by the market, the fund may also get a lower credit rating and consequently a lower NAV.
Diversify
You need to diversify your investments to get the best of everything. A suitable exposure to equities may help in adding that extra zing to your portfolio in terms of long-term capital appreciation. A 100% allocation in any single category of funds, be it debt or equity, can be detrimental.
You may also want to read How To Build A Stable Debt Fund Portfolio?
Key Takeaways
- Choose a debt fund whose duration matches your financial needs.
- Liquid and overnight funds carry the lowest credit risk, ultra short term to short term funds are moderately riskier, and the long duration funds carry the highest risk amongst the debt funds.
- Ratings provided by the credit rating agencies must be a guiding factor.
- A Higher AUM of a debt fund indicates good public response and success of a debt fund.
- A fund with a longer weighted average maturity is riskier than a fund with a lower weighted average maturity.