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5 Facets to Look Into While Investing In Debt Mutual Funds - Outside View by PersonalFN

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5 Facets to Look Into While Investing In Debt Mutual Funds
Jul 26, 2016

A Debt Mutual Fund is a pool of investments holding predominantly fixed income assets. Fixed income securities include: Government Bond, Corporate Deposit, Commercial Paper, Treasury Bills, Money Market Instruments and other debt instruments.

The main aim of debt mutual funds is capital preservation and regular income. But that does not mean that investing in debt mutual funds is risk-free. They, too, are exposed to some element of risk, but are less risky compared to equity oriented funds.

A debt fund manager confronts: interest rate risk, credit risk, liquidity risk and economic risk while managing a portfolio of debt instruments.

Hence, parking your investible surplus in debt mutual funds is not as easy as investing in a bank fixed deposit. You ought to select debt mutual funds very carefully!

Here are facets to look into while investing in a debt mutual fund:

  1. Interest Rates - Interest rates and bond prices share an inverse relationship. When interest rates in the economy move upwards, prices of bonds issued at the rate lower than the new rate fall lower and vice versa. Interest rates are revised regularly by the Central bank as a part of its monetary policy and to keep a vigil on inflation.

    So when you invest, you need to have a fair judgement of where interest rates in the economy are heading to select the right category of debt mutual fund scheme, and whether to invest in long-term or short-term debt funds.
  2. Modified Duration - The interest rate sensitivity of a bond is measured vide its modified duration. Modified duration measures how sensitive the bond price is in relation to change in interest rates. It is a vital measure for you to consider because it includes all components of a bond: price, coupon, maturity date, and interest rate to calculate modified duration. Therefore modified duration can help you recognise that a bond portfolio with high modified duration will have high price volatilty.

    If the fund manager feels interest rates are going to rise, he should, ideally, attempt to reduce modified duration of the portfolio and vice versa.
  3. Yield to Maturity (YTM) - YTM is nothing but an anticipated rate of return if the bond is held until maturity date. It is also known as redemption yield. It measures the interest income generated by the bonds in the portfolio. YTM takes into account: the current market price, the face value, the interest payment that will fall due on the bond and years left in its maturity. But it based on the assumption that:

    - Coupon payments will be made on time, and will be reinvested at the same rate; and

    - The bond is held till its maturity

    It is an indicator of an approximate yield from the bonds that the fund manager has invested in. Hence, if the fund manager has invested in bonds with higher coupon, the portfolio yield will be higher.

    In a steady interest rate scenario, YTM can be used as an approximate measure of the returns that a fund can generate. However, in a falling-interest scenario this will not hold true, as its biggest assumption is that coupon payments will be made on time, and will be reinvested at the same rate. In reality, it is not necessary that the issuer will pay coupon.
  4. Average Maturity - Every debt fund holds fixed income securities which mature in the range of say 30 days to 5 years or more. Ideally, depending on your average maturity profile, you need to select short-term or long-term debt mutual fund schemes that match with your investment time horizon.

    The average maturity of the debt mutual fund scheme should be lower, so that it is less vulnerable to interest rate movements. It should ideally be congruent with the suitable time horizon meant for the particular category in which the debt mutual fund scheme is into consideration. For instance, a liquid fund, which is generally considered for an investment time horizon of less than 3 months, must have its average maturity below 90 days.

    If you have a lower risk appetite, you could select a fund with lesser average maturity. And if you wish to play with a longer duration, funds with higher average maturity may be favourable.
  5. Credit Ratings - As you may know, debt instruments in India are rated on the basis of their credit worthiness by various credit rating agencies such as CRISIL, CARE, ICRA, amongst others. Bond and debentures carry a credit rating like AAA, AA and so on. Each rating denotes certain degree of risk involved -- for example AAA rating indicates highest credit rating. Hence, credit ratings for debt instruments in the portfolio of a debt mutual fund scheme can throw some light on the qualitative aspects as it helps you assess the credit risk -- a risk of default on debt that may arise from a borrower failing to make required payments. If the portfolio consists of securities with highest credit rating, it implies that the portfolio is less exposed to default risk. With the rise in the number of downgrades, it is very important to check how risk-averse the fund manager is and whether your risk appetite is in line with the fund you plan to invest in.

To Sum-up...

Debt funds are an integral part of the overall investment portfolio. Hence, when you're evaluating funds for your portfolio, pay heed to the facets we listed today. Remember, there's more to selecting winning mutual fund schemes for your portfolio than just returns. Adopt a holistic approach. It is important to take cognizance of the risks involved, and do not judge a fund's performance in isolation. Compare funds with peers within a category and against the respective benchmark index, to draw any meaningful conclusions. Also, depending upon the type of the debt mutual fund scheme, it is imperative that it must develop a minimum track record to analyse its performance.

Category Years of Existence
Liquid Funds Minimum 1-year
Liquid Plus / Ultra Short Term Minimum 1-year
S.T. Floating Rate funds Minimum 2-year
L.T. Floating Rate funds Minimum 3-years
Short Term Income Funds Minimum 2-year
Long Term Income Funds Minimum 3-years
Short Term G-Sec Funds Minimum 2-year
Long Term G-Sec Funds Minimum 3-years
(Source: PersonalFN Research)

Further, pay attention to the track record of the mutual fund house, and asses if it follows strong investment processes and systems. A mutual fund house, following a set of prudent investment systems and processes, has greater chances to generate stable returns; as the fund managers need to follow the investment philosophy set by the Asset Management Company. Thus, the debt mutual fund scheme in this case will not be at the sole mercy of the fund manager. It will also take care of the performance risk associated with the sudden change of fund manager. This crucial element will ensure that you invest your hard earned money in mutual fund schemes of a well-established fund house, in the true sense.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "5 Facets to Look Into While Investing In Debt Mutual Funds"

arun

Aug 16, 2016

Thank you for posting this great content. I was searching for this subject for a long time. I found your post quiet interesting. Keep sharing.

Thanks

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