5 Things You Should Consider While Investing In Debt Funds

Debt funds refer to mutual fund schemes that invest in fixed-income securities such as bonds and treasury bills with a motive to earn decent returns. Those who are beginners and do not know about what are mutual fund schemes should understand that a mutual fund is an investment vehicle comprising a portfolio of stocks, bonds, or other securities, managed by a fund manager.

Some of the popular investment options in debt funds include Gilt fund, liquid funds, monthly income plans (MIPs), short-term plans (STPs), and fixed maturity plans (FMPs). In addition to these, debt funds also include various funds that invest in short-term, medium-term, and long-term bonds.

Usually, it is seen that Debt funds are mostly preferred by investors who do not want to invest in the equity market due to market volatility. Compared to stock market investment, a debt fund provides a regular but low income.

In this article, we will discuss 5 important things that you should consider while investing in debt funds. These include Credit risk and interest rate risk, Average maturity, Returns, Assets Under Management (AUM), and expense ratio.

1. Credit risk and interest rate risk:

It is important to note that no investment is risk free and the same applies to debt funds. Debt funds are seen to suffer from credit risk and interest rate risk, which makes them riskier compared to bank FDs. In credit risk, your fund manager can likely invest in low-credit-rated securities that have a higher possibility of default. When it comes to interest rate risk, the bond prices may decline due to a rise in the interest rates.

2. Average maturity:

The right way for investors to understand whether the debt fund matches their financial goal is to check the fund's average maturity. Debt fund managers can invest in debt papers whose maturity might range from one end of the spectrum to another. The average maturity is the weighted average of the maturity period of all the current securities in the fund.

For instance, the average maturity of a debt fund is 0.46 years, in that case, this fund will be suitable for investors looking to park their money for three months or more.

Remember that it is the underlying securities that will mature and not the fund.

3. Returns:

The most important aspect while making any investment decision is the returns you generate from an investment.
Once we decide that this particular fund matches our investment horizon, we should check the past returns delivered by it. Though past returns do not guarantee future returns they act as an indicator and tell us how the fund performed in different market cycles.

The Net Asset Value (NAV) of a debt fund tends to decline with an increase in the overall interest rates in the economy. Hence, they are seen as suitable for a declining interest rate regime.

To make an informed choice you can access the fund's returns for different time frames, past 1-year, 3-year and 5-year, and compare them with benchmarks and peers. If the fund has outperformed the benchmark and has performed better than the category average, then it can be assumed the fund has performed well.

4. Assets Under Management (AUM)

The total assets managed by the fund is its AUM. It is basically the present investment value of all the investors. It is always advisable that retail investors should always invest in debt funds with large AUM. It is because this will protect you from large-scale redemption pressures. If the fund size is small, the fund house might have to sell high-quality debt papers to meet the redemption requests. This affects the returns generated by the fund.

Furthermore, a large fund manager can negotiate for better interest rates compared to a fund with a low AUM.

5. Cost

Your debt fund is managed by debt fund managers and they do not do this for free but charge a cost called an expense ratio. Market regulator SEBI has mandated the upper limit of expense ratio to not exceed 2.25% of the overall assets.

A high expense ratio can significantly impact your returns if not properly understood. When the total expense ratio of the fund is reduced, the returns increase. Conversely, an increase in expense ratio can make investors feel cheated as the amount of return is reduced.