Debt funds are a type of mutual fund that invests in fixed income instruments such as Treasury bills (T-bills), Government securities (G-secs), commercial papers (CP), government and corporate bonds, non-convertible debentures (NCDs), certificates of deposit (CD), and money market instruments. Debt mutual funds are generally considered as relatively safer than equity mutual funds. However, through this article, let’s understand the parameters to consider before you decide to invest in a debt mutual fund.
Risk
Debt Mutual Funds are prone to certain specific risks, namely interest rate risk, credit risk and liquidity risk.
1.a. Interest Rate Risk: The debt fund’s NAV is inversely proportional to the interest rates. Check the duration of your portfolio holdings to assess the interest rate risk.
1.Short-duration funds reduces interest rate risk: If you are conservative regarding the impact of interest rate fluctuations on your mutual fund NAV, you can look at funds with a shorter duration than your current holding period. Very short-duration funds like liquid funds have relatively lower interest rate risk, however, it also means that their average returns are likely to be lower than debt funds with longer duration profiles. Longer duration funds are relatively more volatile compared to short-duration funds.
2. Stay invested to ride out volatility: For longer duration funds of greater than three years, you need to stay invested for the length of the holding period to ride out the volatility due to interest rate changes.
1.b. Credit Risk: Check the monthly factsheet to assess the credit risk in the debt fund portfolio.
Assess the portfolio quality: You can check the credit rating of the underlying instruments in the debt mutual fund portfolio. The credit rating agencies like CRISIL and ICRA assign a credit rating to fixed-income securities based on the financial strength of their issuer. An AAA rating is considered the ‘highest’ rating that carries low credit risk, whereas, a low credit rating like ‘C’; denotes securities at the other end of the spectrum and carry high default risk. Retail investors can consider investment in funds which has invested in high credit rating instruments to minimize credit risk.
Check the YTM (Yield to Maturity) of the fund portfolio : YTM provides an indicative view of the accrual interest income on the fund. A higher YTM that is not aligned with other funds in the same category could imply higher credit risk of the underlying portfolio components. Assess whether the fund might be invested in instruments with a lower rating to achieve a higher portfolio yield.
1.c. Liquidity Risk: Assess the illiquidity of the debt mutual fund. Liquidity risk is the risk of not being able to sell its investments at an acceptable price.
Liquidity depends on the credit quality – good credit quality bonds like government securities or AAA rated bonds are highly liquid while there are only few takers for lower rated debt securities. A debt mutual fund that invests in companies with a poor credit quality could be relatively illiquid in the secondary market.
Similarly, you may avoid liquidity risk by investing in debt fund categories with a shorter duration.
Fund manager experience
Make sure that the debt fund you are about to invest in is managed by a professional, and experienced fund manager.
Tax on Returns
Capital gains tax is based on the holding period. For debt mutual fund schemes, a capital gain for a period of lesser than three years is known as a Short-term Capital Gain (STCG). STCG tax is as per the income slab whereas LTCG (Long-term capital gains) from debt mutual funds are taxed at 20% with indexation benefit.
Conclusion
Debt funds offer convenience, liquidity, relatively low risks, indexation benefit after three years. Investment in Debt Funds could be a core part of your portfolio. But before you zero down on the debt fund, select the right category that suits your risk appetite and investment horizon. Debt Funds should be more about diversifying and adding stability to your portfolio and less about returns.
Disclaimer: The views expressed here in this Article / Video are for general information and reading purpose only and do not constitute any guidelines and recommendations on any course of action to be followed by the reader. Quantum AMC / Quantum Mutual Fund is not guaranteeing / offering / communicating any indicative yield on investments made in the scheme(s). The views are not meant to serve as a professional guide / investment advice / intended to be an offer or solicitation for the purchase or sale of any financial product or instrument or mutual fund units for the reader. The Article / Video has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been solicited based upon the information provided herein, due care has been taken to ensure that the facts are accurate and views given are fair and reasonable as on date. Readers of the Article / Video should rely on information/data arising out of their own investigations and advised to seek independent professional advice and arrive at an informed decision before making any investments. None of the Quantum Advisors, Quantum AMC, Quantum Trustee or Quantum Mutual Fund, their Affiliates or Representative shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary losses or damages including lost profits arising in any way on account of any action taken basis the data / information / views provided in the Article / video.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.