How to Select Debt Mutual Funds to Invest?

In the previous two articles (in this series), we explained the different debt mutual fund categories along with their underlying investments:

  1. Understanding Debt Mutual Funds — Part 1
  2. Understanding Debt Mutual Funds — Part 2

However, the most important task for an investor would be to pick the right category to invest in! In this article we would like to concentrate on the suitability of the categories based on your risk profile, investment objective/goal and investment holding period.

Before getting into the suitability aspect of it, you should know that debt funds are not 100% risk free. Contrary to the common misconception, debt mutual funds have two major risks associated with them (for more on the risks please read— Are Debt Mutual Funds Really Safe?):

  • Credit Risk: It is the risk of default in an underlying security. You can use credit ratings as a proxy for analyzing this risk. A debt fund having majority of its investments in high rated papers has lesser credit risk and vice versa.
  • Interest rate risk: It is the risk of price fluctuation in a debt security with change in interest rates in the market. You can use modified duration of the debt fund as a proxy to analyse interest rate risk. It indicates the change in the price of a debt security with a 1% change in interest rates. Higher the modified duration, higher is the interest rate risk.

Suitability

To evaluate which category of debt funds are suitable for you to invest in, you should keep in mind the following:

  • Your Investment objective
  • Your Investment holding period
  • Your risk profile
  • Risks associated with the debt category

As discussed earlier, debt mutual funds bear interest rate risk and credit risk. To minimize these risks, you can use a two-step process as explained below:

  1. Minimize interest rate risk by matching your investment holding period with the duration of the debt fund
  2. Be aware of your risk profile and your investment objective to avoid taking on unnecessary credit risk. Your risk taking ability should be in line with the risks associated with the debt category to avoid any undue surprises

Let us consider a few scenarios to understand this well.

Suppose you have extra cash in hand and its utilization is not planned yet. Here your investment objective is purely capital protection (i.e. keep principal amount intact at all times) while earning returns slightly higher than savings account interest. To achieve this objective, pick debt categories which have minimal risks such as Overnight/ Liquid. These categories are also best suited to create your emergency fund as well.

If your objective is to park your money for around a year while earning returns higher than fixed deposit interest, you can consider investing in Ultra short, Low duration and Money Market categories. Now based on your risk profile, you can choose a fund with appropriate credit rating. For example, a conservative investor should look for funds with a higher AAA/A1+ or sovereign exposure in their portfolio as they carry negligible credit risk. Choosing longer duration debt categories like Medium, Long duration etc. for this investment holding period will expose you to higher interest rate risk which could also result in loss of invested capital.

Going by this principle, if you are looking to stay invested for 2–3 years, you can consider short duration funds. For investment horizons of more than 3 years you can look at categories such as medium duration, long duration and so on, as long as you pick the funds based on their underlying credit ratings which suits your risk profile.

Now a question that must be bothering you is how to choose among debt categories which have no stated duration guidelines i.e. theme based debt categories. These categories should usually be considered for an investment horizon of 3 years or longer.

Gilt funds as you already know invest predominantly in Government securities which carry negligible credit risk. A risk averse investor can choose this category if the objective is long term stable capital appreciation. These funds generally tend to have a longer duration. So make sure your investment holding period is almost the same as the fund’s duration to avoid unnecessary volatility.

On the other end of the risk spectrum is the credit risk category, which seeks to provide higher returns by investing in lower rated securities and hence carry higher risk of default. Always remember, higher returns come with higher risks. Investors should tread with caution while planning to invest in this category.

Corporate bond and Banking & PSU categories lie in between Gilt and credit risk funds in terms of the credit risk they bear. Both these categories can be considered by investors whose objective is stable capital appreciation over the medium term.

Hence, using the two-step process, you would have a list of funds that you can invest into. Lastly, while investing, remember to choose funds with large AUM to protect yourself from sudden large redemption pressure.

We hope that now you have a fair idea on how to go about your debt investments. Keep in mind that investing, be it in equity or debt, is a lot more than just chasing returns. Do make informed investment decisions keeping in mind your risk profile, investment objective and investment holding period.

Consult your financial advisor while investing in the right mutual funds, so that you don’t get surprises with your hard earned money. To help you with your decision making process, we have analysed select debt funds based on the above mentioned risks and other relevant qualitative and quantitative parameters. Our curated list of debt mutual funds can be found under Investment Ideas “Better than Fixed Deposit” and “Better than Savings Account”.