Debt mutual funds are a good investment product as they provide stability, regular income, liquidity, and capital preservation. Whether you are a beginner or an experienced investor, you can benefit from understanding debt funds better and maximising their potential. In this article, we will explore important factors to consider when investing in debt mutual funds, empowering you with the knowledge to make informed decisions.
- Credit rating
Debt mutual funds invest in a variety of fixed-income securities issued by governments and corporations. One crucial factor to assess is the credit rating of these securities. Credit rating agencies assign ratings based on the issuer’s ability to repay the debt. Higher-rated securities (such as AAA or AA) are considered more stable and have lower default risk, while lower-rated securities (such as BB or below) carry higher credit risk but may offer higher yields, like in the case of credit risk funds. It’s important to understand the credit quality of the underlying securities of the debt fund to evaluate the associated risk.
- Interest rate risk
Debt funds are exposed to interest rate risk, which arises from changes in prevailing interest rates. When interest rates rise, fixed-income instruments such as bonds experience a fall in prices, leading to potential capital losses. On the other hand, falling interest rates can boost bond prices, resulting in capital gains. The extent of interest rate risk varies based on the average portfolio maturity and modified duration of the fund.
- Average portfolio maturity
Average portfolio maturity refers to the average time remaining until the debt securities held by the fund reach their maturity dates. Funds with shorter average maturities are less sensitive to interest rate fluctuations and tend to have lower interest rate risk. These funds, such as liquid funds or ultra-short duration funds, are suitable for investors with short investment horizons or those seeking high liquidity. Funds with longer average maturities, such as long duration funds, may offer higher yields but are more sensitive to interest rate movements.
- Modified duration
Modified duration is a measure of the sensitivity of a bond or a debt fund to changes in interest rates. It estimates the percentage change in the price of the security for a 1% change in interest rates. Funds with higher modified duration are more susceptible to interest rate risk, as their prices are more likely to be impacted by changes in interest rates. Investors with a low risk tolerance or shorter investment horizons may prefer funds with lower modified duration to mitigate interest rate risk.
- SEBI classification:
It’s also important to familiarise yourself with the classification of debt funds by the Securities and Exchange Board of India (SEBI). This classification categorises funds based on their investment objectives, average maturity, credit quality, and underlying securities. It will help you choose a fund that meets your specific investment needs. SEBI has classified debt funds into 16 categories including overnight funds, liquid funds, gilt funds, etc.
Now that you know these important factors about debt mutual funds, you can align your investment objectives, investment horizon, and risk tolerance with the right debt fund. Remember, it’s essential to conduct thorough research, seek professional guidance when needed, and stay updated with market trends to maximise the potential of your investments in debt mutual funds.