Debt funds are a category of mutual funds that invest a significant portion of your invested money into fixed-income bearing instruments such as debentures, government securities, corporate bonds, treasury bills and money market instruments.
They try to optimize returns by diversifying across different types of securities, fetching decent returns consequently. Debt mutual fund returns often fall in a predictable range and hence suitable for conservative investors. They are also suitable for people with both short-term and medium-term investment horizons – short term ranging from 3 months to 1 year, while medium-term ranging from 3 years to 5 years.
Although debt funds are considered to be relatively safer than equity mutual funds since they don’t invest in market-linked securities, they are still prone to certain specific risks, namely credit risk, interest rate risk, and liquidity risk.
This calls for investors to be aware of these risks, especially after the recent defaults and downgrades that have affected debt funds. Keeping this in mind, here are a few factors to consider before you invest in debt mutual funds.
In this article
The expense ratio is the aggregate of expenses incurred for running the debt fund scheme. Expense ratio in debt funds plays a more important role than in equity mutual funds because the returns or the upside is limited for debt funds.
A direct plan should be the preferred choice for investors where the expense ratio is significantly low. Investors should calculate the returns from debt fund after taking into consideration the expense ratio. For example, if the return from a debt fund is 9 % and the expense ratio is 1.5 %, then the actual return for the investor will be 7.5 % only.
Maturity And Duration
Debt mutual funds are more vulnerable to interest rate movements. Generally, there is an inverse relationship between bond price and interest rates. Modified duration is simply a price sensitivity of a debt fund to change the interest rate.
It shows how interest rate changes affect debt fund NAV (net asset value). The longer the modified duration, the more sensitive is the particular debt fund to interest rate changes and vice versa.
This means that debt funds with longer modified duration perform well in the falling interest rate regime, and funds with shorter modified duration perform well in rising interest rate regimes. Longer duration funds are more volatile in comparison to shorter duration funds.
So both the maturity and duration of a debt fund hence play an important role.
Yield To Maturity
Yield to maturity in a debt fund is an expected rate of return if all the securities in the fund portfolio are held until maturity. For example, the yield to maturity of a debt fund is 9%. The investor will earn a return of 9% if the portfolio remains constant until all the holdings in the portfolio mature.
However, if the fund manager follows active management of the portfolio as a strategy, yield to maturity would not give a definitive indication of returns.
If you invest in short-term debt funds of less than three years that employ an accrual strategy, it’s crucial to consider the yield to maturity alongside the credit ratings of underlying securities in the portfolio.
Interest Rate Regime
The interest rate regime will have a great impact on the attractiveness of debt funds. In a falling interest rate regime, the value of previously issued bonds will be higher than freshly issued bonds.
In the case of a rising interest rate regime, the value of previously issued bonds will reduce as investors would be keener to invest in newly issued bonds with a higher rate.
As debt mutual funds invest in bonds, they generally perform well in the falling interest rate scenario as the existing bonds in the portfolio will have a higher coupon rate. Hence, while selecting a debt fund, it’s important to consider the prevailing interest rate regime and other factors.
Credit Risk Of Portfolio Constituents
Along with interest rate risk, debt funds also carry credit risk. Debt securities are rated by the credit rating agencies on the issuer’s creditworthiness and capacity to pay back.
Fixed income securities that are rated AAA are considered ‘highest’ that carry low credit risk. Securities that receive low credit rating like ‘C’ carry high default risk.
Hence, it’s crucial to check the credit ratings of each portfolio constituents of the debt fund. A portfolio that constitutes fixed income securities that are highly rated is ideal to invest in.
Weighted Average Maturity Of the Fund
A debt fund invests in various debt instruments having different maturities. Depending on these maturities, one can determine whether the fund is short term, medium-term or long term.
Weighted average maturity is calculated by considering the maturity period of an asset held by the fund and the weightage of that holding in the fund’s total assets. Funds with a higher weighted average maturity can deliver greater returns due to their ability to hold longer. However, there is a greater risk associated with long-duration funds due to interest rate fluctuations. As a result, there may be more fluctuations in the NAV of the fund.
Assets Under Management (AUM)
AUM means the market value of investments held by a mutual fund. Debt mutual funds rely highly on their AUM to manage their returns and dividends to investors. A debt mutual fund with a high fund size or larger assets under management is in a better position to distribute fixed fund expenses across its investors. A large fund size would mean a lower expense ratio per person, which is reflected in the fund returns.
Also, if the fund house has a larger fund size or assets under management, it helps negotiate better with the debt issuers courtesy of the size.
Read more on Groww: Should You Consider Mutual Fund Size (AUM) While Investing?
To Sum Up
Debt funds come with benefits like convenience, regular income, high liquidity, low risks and reasonably predictable returns. Also, the benefit of Indexation available for debt funds after three years makes for tax-efficient investments. Needless to say, debt mutual funds are definitely great investment vehicles if you select them smartly based on your investment objective and risk appetite, along with considering the key factors that have a direct impact on the fund’s performance.
Disclaimer: The views expressed in this post are that of the author and not those of Groww.
Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. NBT do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.