Selecting The Right DEBT Mutual Fund
Selecting The Right DEBT Mutual Fund Debt funds are as versatile as equity funds. DSIJ guides on how to use debt funds to complement your equity portfolio.
We have talked a lot about the equity funds in our magazine, however we have till now not looked at the debt funds. The reason being most of you are interested in equity investments as these are made for the long term and give better returns than debt funds in the long term. Nevertheless, as an investor, you need many more options to achieve your financial security and safety. Debt funds provide you such options.
The debt funds come in different shape and sizes. These funds can be used to fulfil your short term as well as medium term needs and can be mixed with equity funds to perk up returns. Unlike the equity funds that are normally used for the long term, the debt funds can be used for the short term too. Even under SEBI's directive on categorisation and rationalisation of mutual fund schemes, the types of debt funds are more than the types of equity funds. There are 10 categories of equity funds while there are 16 categories of debt funds.
There are various options available in the debt fund category. However, before zeroing down to any category, you should keep the following aspects in mind. At the very basic level, there are only two parameters on which you can gauge the suitability or otherwise of a debt fund for you. First is its maturity period and the second is the credit risk.
Your investment horizon should match fund's maturity
One of the characteristics based on which debt mutual funds are classified is the maturity of the debt or securities. Therefore, the first thing you should understand is the period for which you are going to invest. The period should match with the fund's maturity profile. You can know the fund's maturity profile through the fund's fact sheet available on the AMC's website. At the end of every month, the fund house publishes details of all the assets wherein the individual fund has invested, including equity and debt. The average maturity indicates the average time to maturity of all the debt securities held in a portfolio. The longer the maturity period of a fund, the more the fund's sensitivity to changes in interest rates. Nevertheless, a fund's modified duration, which again can be found in the fact sheet, reflects the funds interest rate sensitivity in a better way.
Interest rates play the most important role in determining the returns from a debt fund. The reason being the price of a bond and interest rate have inverse relationship, which means that as interest rate goes up, bond prices fall, and vice-versa. The modified duration gives you an indication of how much the bond's prices will rise or fall with rising or falling interest rate. The change in the price of a bond is a product of its modified duration and the change in interest rate. Therefore, if the modified duration of a fund is 1.3 years, it means that for every one per cent increase in interest rate, the bond price will fall by Rs 1.3. Similarly, if interest rate goes down by 1 per cent, bond prices will go up by Rs 1.3. At the current juncture, when the interest rate is likely to go up, funds with lower modified duration are preferred, with the usual caveat of other things remaining the same.
Risk Appetite
Besides the modified duration, the riskiness of a debt fund is determined by the credit risk. The duration risk involves risk of including bonds that have a duration that will go against the interest rate movement. So, in a rising interest rate scenario, bonds with a higher duration will yield negative returns, while in a falling interest rate scenario, the lower duration bonds will have a negative implication for the fund. Nonetheless, the credit risk involves investing in lower credit-rated instrument to earn higher interest. The credit rating of the security is listed alongside its name in the mutual fund fact sheet. The higher rated instruments have lower probability of loss. The credit risk also comes with liquidity risk. Hence, investing in papers will lower rating may also have higher impact cost while liquidating. However, these credit risks are well compensated by higher returns provided by these papers. For instance, a 5-year A-rated bond, as per CRISIL's bond matrices, yields about 200 bps over AAA-rated bond of similar maturity. Therefore, before investing in a debt fund, you should check the credit quality of the papers in which it has invested.
What should you do now
Currently, when the interest rate is in an upward cycle (See: Rate Cycle) and there is volatility in the equity market, investment in debt funds becomes a tricky proposition. Therefore, before investing in debt funds for longer duration, experts suggest looking at the average yield of the 10-year benchmark securities over a period which roughly covers the interest rate cycle. We have taken the last five years as that cycle. Take the average yield of that period and compare it with the current yield. If the prevailing yield is higher than this average yield, you can still invest in debt funds for longer duration. This is because chances of the prevailing yield moving towards the average yield are more than that of these yields moving away. However, if the prevailing yield is lower than average yield, then there are more chances of the current yield returning to the mean yield. So, when yields go up, prices of debt securities– and, therefore, the NAVs of debt funds–go down. Though the 10-year benchmark yield is currently above the long-term average, there are reasons to believe that it is going to inch up further before returning to mean. Therefore, it is not the right time to enter debt funds that invest in long term securities. 
Nevertheless, there are opportunities elsewhere in the debt funds. Depending upon the individual's risk appetite, one can opt for Fixed Maturity Plans (FMPs) to short-term debt funds. FMPs are closed-ended funds where maturity is defined. These products typically follow buy and hold till maturity strategy in their portfolio. An FMP has a predictive return that matches the yield of securities in its underlying portfolio. As rates are rising, short term debt funds can also be a good bet as these funds exhibit lower volatility. Besides, the dynamic bond funds are also recommended many times as they invest across different maturity profiles. However, these have not performed up to expectation in the last one year.