How To Select Best Debt Mutual Fund for Investment

In this, we will tell you how you should invest in debt mutual funds. Let us begin by understanding the risk associated with debt mutual funds. There are two big risks in a debt mutual fund.

  • Interest Rate Risk
  • Credit Risk
How To Select Best Debt Mutual Fund

What is Interest Rate Risk?

Debt funds invest in debt instruments Like stocks, bonds, NCD etc. are traded on the daily basis in the market and their prices keep going up and down, especially depending on how interest rates are changing or what kind of changes people expect from them. Whenever interest rates fall or people think that interest rates are going to fall, then high demand increases the bond price. This is understood from an example - suppose a debt fund holds a bond which gives 10% annual interest rate. Now if interest rates fall in the economy, then any new bond coming into the market will give a lower interest rate like 9%. And this will increase the demand for old bonds which are paying higher interest rates, due to this price of the bond and the NAV of the debt fund holding it later also increases. Likewise, if the interest rate goes up then the bond price will come down because now the demand for these bonds giving lower interest rate will also decrease because of interest rate, the price movement of the bond is called interest rate risk.

What is Credit Risk?

You may have heard of personal credit scores such as CIBIL scores, which show how well you have repaid a debt like loan in the past and based on that it gives you a score. In the same way there are ratings for a company. These agencies are called credit rating agencies. CRISIL and ICRA are two similar agency. These agency would look at the financial and past history of a company and assess its debt repayment capability. And then a rating is given to show this capability. AAA is the highest rating that shows that the company is almost certain to pay its debt and therefore has a lower credit risk. The next is AA, which points towards lower certianity, so it has a slightly higher credit risk. Similarly, this rating is up to D. D is given when a company has not repaid its loan or it seems that it will not be able to repay the loan. The best way to avoid this kind of risk is that you Invest in debt funds that consistently perform good or its rating is AA/ AAA only.

Now that you know about the risk, let's see how you can invest in debt funds to get a better understanding of you. we have made the most popular debt fund category is divided into 3 different types. It is easy to understand, hence they are named:
  • Safety First
  • Better Than FD
  • Beat FD Returns

Safety First:

In this category, we have two type of funds Overnight Fund and Liquid Fund. These are the safest funds with credit risk. These funds have the highest priority with both safety and liquidity returns. While they are considered a good option to keep cash which helps you withdraw money quickly in emergency, but you Can also be used to invest for long duration. If you are a Conservative Investor, then all for your debt allocation pick one of these two categories of funds. Ideally, overnight funds are good for up to 7 days of tenure. You can consign a liquid fund with an investment horizon of more than a week.

Better Than FD: 

These fund categories are being generated higher returns than FDs in the same investment duration's. We have Low Duration Funds, Short Term Funds, Corporate Bond Funds, and Banking & PSU Funds are falling under this category. These high credit quality bonds (AAA or its equivalent), these funds have very low interest rate risk and credit risk, making up the majority of their portfolio. These type of debt funds give slightly higher returns than safety first debt funds without compromising your investment safety. If you are thinking of investing for 6 months to 1 year, then you can choose a low duration debt fund. For an investment period of 1-3 years, if you can take a little risk, then all other categories are right.

Beat FD Returns:

This category belongs to those investors who want to get higher returns from FDs and are also willing to take a higher risk for these higher returns. We have Dynamic bond funds, credit risk funds and debt-oriented hybrid funds are falling under this category. These funds adopt a different approach to generate higher returns than FD. These approaches take a rate of interest rate risk or add a small portion of direct equity stock to the portfolio from a mix of credit rate and interest rate risk. Let's know about those approaches in detail to understand better.

Interest Rate Approach:

In this approach, the fund manager actively assigns different tenant bonds according to interest rate risk. Buy and sell at the right time for good returns. A dynamic bond fund uses this strategy. However, for this strategy to be successful, the fund manager will have to time the interest rate cycle properly, because a wrong step can cause damage.

Credit Approach:

Here, higher returns are generated by investing in highly profitable lower-rated instruments. Credit risk funds follow this approach. Even though there are some interest rate risk in these funds, there is still a bigger risk than credit risk. 

Investment in very poor quality or low-quality bonds of the portfolio means that you may suffer a loss if the relative company's repayment capability is negatively impacted by the Economic Distress or the Unfavorable Business Cycle.

Hybrid Fund Approach:

In this approach , Funds allocate 10-40% of their portfolio to equity to increase returns. Equity saving funds and Conservative hybrid funds are its examples. While Conservative funds invest 10-25% of their money in equity and the rest in debt. Equity savings funds invest in a mix, arbitrage and equal proportion in debt. Because these funds have a portfolio of equity exposures, the debt portfolio of these funds usually consists of bonds with low risk high credit quality papers and low interest rate risk. 

All these categories falling within the Beat the FD type are ideal only when You are thinking of investing for at least 3 years and are also ready for volatility during the investment. 

Overall, investing in debt funds should be the most important part of any asset allocation. But before deciding which fund to invest in, it is important to know about the category that suits your risk appetite and investment horizon. It is always good to keep in mind that debt funds should be used more to give stability to your portfolio and less for higher returns. Keeping this in mind, most investors can get good returns by keeping their investments up to safety first and better than FD type debt funds. Now that you know how to pick a debt fund.

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