The following are some of the parameters the investor can look before deciding investing in debt fund.
Given that people devote much more time and effort to picking equity The large number debt fund categories are available like liquid, income, short-term, ultra short-term, gilt, monthly income plans, fixed maturity plans, etc.
Letís examine some of these.
Time horizon and fund maturity
As a debt fund investor, you should first ascertain the period for which you want to stay invested. This is because the maturity profile for each category is different. Ideally, you should look at investing in fixed income funds that are in sync with their investment horizon and risk profile."
So, if you are looking at an investment horizon of, say, three months, don't invest in liquid funds. Instead, opt for ultra short-term funds, where the average maturity of the underlying paper is up to 90 days. For those wanting to stay invested for a year or more, income funds or fixed maturity plans are the best option. Also, keep in mind that short-term gains in debt funds are taxed according to the applicable tax slabs, whereas long-term gains are eligible for the inflation indexation benefit.
Though, Debt funds are primarily geared towards protecting capital and providing stable returns over reasonable periods of time while keeping risk under manageable levels. As the safety of capital is of utmost importance to a debt investor, one should not go for funds with low quality investments.
The quality of debt instruments in the fund's portfolio should be scrutinized closely. Each instrument is assigned a credit rating that signifies the level of default risk. The higher the rating indicates the safer the instrument. To check this, investors can go through the offer document as well as the subsequent fact sheets published by the mutual fund. A debt fund may invest in several instruments, ranging from risk-free government securities to high-risk corporate paper.
A fund holding large amounts in a poor quality paper may find it difficult to sell such securities in the market, thereby putting your money at risk. While a debt fund with a risky paper is likely to yield higher returns.
Returns and Interest rates
The value of debt funds depends on the common interest rates. If the rates rise, debt funds loose value, and vice versa. This is because of the inverse relationship between interest rates and bond prices. However, short-term debt instruments are less sensitive to rate movements compared with the long-term ones. So, when interest rates are on the rise, it makes sense to move to short-term funds, and vice versa. As a thumb rule, liquid funds provide the least risk, followed by liquid plus funds. The funds bearing marked-to-market risk, such as income funds or long-term gilt funds tend to under perform in a rising interest rate scenario over the medium to long term, the schemes that emphasise shorter term securities and higher credit quality tends to be more conservative than the ones offering longer maturities (and, hence, increased interest rate sensitivity)."
Unlike an equity fund, the expense ratio is critical for a debt fund as the returns are low. As most debt funds offer returns in the range of 7-10%, having an expensive cost structure will be a huge drag on the returns. So the investors should ensure that the cost structure is reasonable and in line with the returns being offered by the fund. For instance, it doesn't make sense to pay a charge of 2.25% for a paltry return of 3-4% or lower (see Funds with high costs, low returns). If you adjust for inflation, you are effectively earning a negative return on your investment.
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