In debt we trust

May 06 2014, 08:52 IST
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SummaryTake note of a few things if you plan to make the most of rising interest rates by investing in debt funds

With interest rates on a high, itís time for you to give debt funds a serious consideration, if you havenít already. A debt fund is a type of mutual fund that invests in both deposits and bonds.

What does an individual investor do with his surplus money? Typically, he makes a bank fixed deposit, invests in bonds or puts the money in corporate fixed deposits. A debt mutual fund makes life simpler, by investing your money in various fixed-return instruments. However, there are certain aspects that you must keep in mind while investing in a debt fund.

Tenure

This is a crucial factor because a longer tenure means additional risk and higher exposure to interest rate fluctuations. The bond value is inversely proportional to the interest rates ó a rise in interest rates results in a fall in the price of bonds and vice-versa. Short-duration bonds have lesser chance of being affected by significant interest rate fluctuations than long-term bonds. For example, the price of a five-year bond will fall 5% reacting to a rise in interest rate by 1%. An investor should keep in mind his risk appetite and return expectations before choosing the tenure. Itís also important to analyse the interest rate trend before investing.

Investment quality

The investment quality of a bond is determined by the credit rating assigned to it based on assessment of various risk factors. A high-risk bond offers higher returns, but is assigned a lower rating and, similarly, a low-risk bond offers lower returns, but is assigned a higher rating by credit rating agencies. Debt fund managers, sometimes, take higher position in bonds with lower ratings to maximise profit, but, at the time of redemption, such bonds lack liquidity. Therefore, investors should focus on funds that invest only in medium-to-high credit rating bonds and debt instruments.

Fund charges

Some debt funds attract investors with lucrative returns, but, on the other side, trap them by levying exit loads. Check the exit load, other associated charges and the lock-in before investing in any debt fund. A debt fund with a higher expense ratio needs higher returns to cover the expenses. Therefore, fund managers could go for lower rated bonds to fetch higher returns. Also, higher associated fund charges would reduce the actual benefits. Therefore, a debt fund with a lower expense ratio should be preferred.

Size of a debt fund

A debt fund with a large corpus means greater

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