How To Choose The Debt Fund For Your Portfolio?
Mutual funds have continued to be preferred by the retail investors with sustained SIP inflows during recent times. Investors may choose from a vast universe of mutual funds, which may be primarily classified into five major categories – equity funds, debt funds, hybrid funds, solution-oriented schemes, and other funds. Different types of mutual fund schemes tend to suit investors with different variants of risk profile, investment horizon, financial goals, etc. This article will focus on helping the investors choose the debt funds for their portfolio.
Debt funds tend to provide returns through the underlying portfolio of fixed-income debt securities predominantly. However, the investment in debt funds is also subject to inherent investment risks, and different debt funds available may expose the investors to varying degrees of interest rate and credit rate risk.
Interest rate risk refers to the sensitivity of the investment portfolio to the changes in interest rate movements. The valuation of debt securities tends to be inversely proportional to the interest rate movements. Thus, the valuation of debt securities tends to increase as the interest rate decrease. In contrast, credit risk refers to the risk of the issuer entities defaulting on the debt servicing obligations. As such, the investors may be at risk of generating negative returns due to the markdown in portfolio valuation due to the default expectations.
With the above background, here are the different broad categories of debt funds:
1. Overnight and Liquid Funds:
Such funds invest in securities with one business day maturity and maturity of up to 91 days, respectively. With lower maturities, such funds have low market risk due to interest rate movements. Further, the credit risk may also be low, considering such funds invest in sovereign securities and money market securities for shorter maturities.
2. Duration funds:
Such funds invest in debt securities with varying durations. Examples of duration funds are ultra-short duration fund, short-duration fund, etc. Such funds may help the investors manage the interest rate risk in their investment portfolio.
3. Gilt funds:
Such funds invest a minimum of 80% of its net assets in Government Securities (G-Secs) only. These funds help the investors mitigate the credit risk in their investment portfolio. However, the investors may still be exposed to interest rate risk as per the fund duration.
4. Fixed Maturity Plans (FMPs):
Such funds carry fixed maturity and maynot be prematurely redeemed through mutual fund houses and typically invest in securities matching the scheme maturity.
Few variation of debt funds are also available.
How to select debt mutual funds?
The investors may consider the following while selecting the debt fund for their investment portfolio:
Know the Purpose first – It is always good to link the financial goals with specific investments. It will also help the investors to choose the debt scheme, best suiting the desired purpose and investment horizon. For example, a long duration gilt fund may not be suitable for maintaining an emergency fund corpus. In contrast, a liquid fund and an overnight fund would be more suitable in such a scenario. Similarly, for financial goals with definite maturity, one may consider investing in FMPs with matching tenors. Further, the debt scheme should ideally match the investment horizon suitably.
Balancing the Risk-Reward Trade-Off – Different debt schemes carry different risk profiles. While one fund category may mitigate the portfolio against interest rate risk like dynamic bond fund, floater fund, etc., another category may insulate the portfolio from credit risk, e.g., gilt funds, etc. The investors must must condiser their risk appetite and take investment decisions accordingly. Taking a higher risk than what the risk appetite allows may spoil the investment experience for the investors and, thus, not desirable. Further, the investors must also moderate their return expectations suitably, which should be commensurate with the risk being undertaken, as the markets tend to compensate the investors with higher returns only through higher risk. For example, a completely conservative debt fund, like an overnight fund, will tend to generate lower returns amongst the overall debt fund category.
With the above considerations, the investors must make an informed decision about choosing the right debt fund for their investment portfolio.