Debt funds have become more popular these days, and now, people have started using these in place of fixed deposits. Usually, debt funds also have higher returns than fixed deposits. Here’s why debt mutual funds are better investment option.
What is a debt mutual fund?
The concept of debt mutual funds is simple. They generate a return by investing money in various deposits and bonds. Basically, we lend money and receive interest on the amount.
Terms to remember
1) Modified duration: This duration is the measure of sensitivity of a bond. For example, let’s say, interest rate increases by 1%, then for a 4-year modified duration, NAV will increase by 4%.
2) Average maturity: There are several bonds in a debt fund portfolio, and average maturity is the maturity average of all these bonds.
Yield of maturity: This is the measure of total earning of the bond if it is held till maturity.
Things to remember
1) Time duration: Evaluate the time period for which you want to invest your money and then match it with the maturity of the fund.
2) Credit rating: Debt mutual funds invest in various instruments including corporate bonds that are risky and government securities that are risk-free. Check the credit rating before investment. If you are already fearful of investing in debt funds, then go for a fund with high credit rating.
3) Interest rate: Analyze the interest rate. If the interest is high, moving to short-term funds is sensible. If interest is low, long-term funds are beneficial.
Risks involved in debt mutual funds
Credit risk: It is a risk that occurs when the borrower or issuers fails to pay the payments. So, it is essential to go through risk profile before investing because low credit quality can increase returns, but this also increases credit risk.
Interest rate risk: This involves fluctuation in interest rates, and it can affect the bonds prices.
Liquidity risk: Liquidity is how easily security can be sold in the market, and liquidity risk arises when selling security is hard without losing some capital.
Best debt mutual funds
1) Short-term funds
• Invests in CD (certificate of deposit), commercial papers, and 3 to 6 months maturity bonds
• Low risk, and when interest rates changes, these are not affected greatly
• Only 6 to 12 months of holding period
• People who are looking for higher return and want to invest extra money for a short duration should invest in short-term funds
2) Gilt funds
• Invests in government securities of all types with different maturities
• While default risk is low, risk associated with interest rate is high
• 18 to 24 months of holding period
• People who are experienced in investment and are not scared of the risk factor involved should invest in gilt fund. This fund is for those who want capital appreciation rather than investment security
3) Credit funds
• Invests in instruments with less credit quality but yield high returns
• Interest rate risk is less, but if the credit rating of the instrument is reduced, it can hurt NAV
• 3 to 5 years of holding period
• People who are willing to take more risk for more yield should invest in credit funds
4) Fixed maturity funds
• Invests in instruments that have same maturity as the fund’s tenure
• Risk factor is low to medium
• 3 or more years of holding period
• People who want to invest for a fixed period should invest in fixed maturity funds
5) Liquid funds
• Invests in liquid instruments such as money market interbank call or treasury bills
• Risk factor is very low
• Up to 3 months of holding period
• People who are looking for higher interest rates than banks should invest in liquid funds
6) Dynamic and income bonds
• Invests in both government securities and corporate debentures
• Risk factor ranges from medium to high
• 3 to 5 years of holding period
• People who have high experience in investing in debt funds and want to reap benefits of both falling and rising interest should invest in dynamic bonds
Debt mutual funds have the power to offer more returns than fixed deposits. However, you should always invest according to your requirements and needs. If you are too afraid to lose your money, then prefer low-risk debt funds or simply go for fixed deposit.