Debt funds: Here are five factors you need to consider

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Updated: March 4, 2019 7:20:26 AM

The degree of increases or decreases in their NAV would also depend on the maturity of their constituent securities.

However, YTM is not the sole indicator of the possible gains from a debt fund as the actual return would also depend on the mark-to-market valuations and changes in the portfolio.

With 16 debt fund categories and about 330 individual debt funds (excluding fixed maturity plans) to choose from, finding the best debt fund for generating optimal risk-adjusted returns can be trickier vis-à-vis equity funds. Wrong choice can lead to sub-optimal returns or even capital erosion. Here are some factors that should be considered while selecting debt funds:

Optimum debt fund category

dentify your risk appetite and time horizon of financial goals. The Sebi circular on mutual fund categorisation is an excellent tool as it categorises debt funds on the basis of risk rating, residual maturity and portfolio constituents of fund portfolio. For example, corporate debt funds, as per the circular, have to invest at least 80% of their corpus in highest rated corporate bonds, whereas at least 65% of a credit risk fund’s portfolio has to be invested in below highest rated instruments.
Once you find out the appropriate fund category, consider the following quantitative indicators in various debt fund portfolios within selected fund category.

Average maturity

Average maturity is the weighted average of maturities of debt instruments held in its portfolio. Modified duration refers to the sensitivity of a debt fund’s portfolio to changes in interest rate. Higher the average maturity and modified duration of a debt fund, higher would be its sensitivity to changes in interest rates. Thus, those with higher average maturity and modified duration do well in falling interest rates whereas those with lower average maturity and modified duration perform better during rising interest rates.

Expense ratio

Consider the expense ratio—proportion of a fund’s assets used to meet its total expenses—while choosing debt funds, especially liquid, ultra-short and low duration funds, as they come with limited upside potential when compared with equity funds. Opt for direct plans of debt funds as they have lower expense ratio than their regular counterparts.

Yield to maturity

Yield to maturity (YTM) of a debt fund is the weighted average yield of its portfolio constituents. Funds investing in debt securities with higher coupon rate would have higher YTM than others. Thus, YTM of a debt fund will give fair idea about the interest income that can be accrued in a stable interest rate scenario if all its portfolio constituents are held till their respective maturity dates. However, YTM is not the sole indicator of the possible gains from a debt fund as the actual return would also depend on the mark-to-market valuations and changes in the portfolio.
Investors should consider net YTM of the portfolio, which is the function of gross YTM minus the expense ratio.

Portfolio constituents

Debt instruments with credit rating of AAA denote lowest credit risk while those with C have high default risk. As securities with lower credit ratings have the potential to generate higher returns, analysing the fund’s portfolio constituents would also help you in assessing the fund’s upside potential. Go through the portfolio section of debt fund’s fact sheet to decide whether its credit risk profile suits your own risk appetite and return expectations.

Current interest rate regime

Price of debt securities increases during falling interest rate regime, given that their coupon rate tends to be higher than the ones offered by newly issued debt securities. The opposite happens during rising interest rate regime as investors prefer to invest in newly issued securities with higher coupon rates. As a result, debt funds register higher returns during falling interest rate regime and vice versa. The degree of increases or decreases in their NAV would also depend on the maturity of their constituent securities.

The writer is CEO & Co-founder,
Paisabazaar.com

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