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5 Factors to Keep in Mind While Investing in Debt Funds

Updated on :  

08 min read.

Debt funds are mutual funds that invest a substantial portion of the money in fixed-income instruments like debentures, government securities, corporate bonds, treasury bills, and money market instruments.

They attempt to maximise returns by diversifying through various types of securities, resulting in respectable returns. Debt mutual fund returns are mostly stable, making them a good option for cautious investors. They are also appropriate for investors with short and medium-term investment horizons, with short-term horizons varying from three months to one year and medium-term horizons ranging from three to five years.

1. Expense ratio

The cost ratio is the amount of all expenditures incurred in the debt fund scheme’s operation. Since the returns or upside potential of debt funds is small, the expense ratio is more critical than equity mutual funds.

For investors who have a low-cost ratio, a direct plan should be the preferred option. After accounting for the cost ratio, investors can calculate the returns from debt funds. For example, if a debt fund’s return is 9% and the cost ratio is 1.5%, the investor’s real return would be just 7.5%

2. Maturity and Duration

Interest rate fluctuations are more vulnerable to debt mutual funds. Bond prices and interest rates have an inverse relationship in general. The modified period is essentially a debt fund’s price sensitivity to interest rate changes.

It demonstrates how increases in interest rates impact the NAV of debt funds. The longer the adjusted period, the more vulnerable the debt fund is to interest rate increases, and vice versa.

This means that debt funds with a longer modified duration perform well in a declining interest rate environment, while debt funds with a shorter modified duration perform well in an increasing interest rate environment. In contrast to shorter-term funds, longer-term funds are more volatile.

3. Yield to maturity

In a debt fund, the yield to maturity is the estimated return rate if all of the securities in the portfolio are kept until maturity. If a debt fund’s yield to maturity is 9%, for example, the investor would gain 9% if the portfolio stays unchanged until all of the holdings in the portfolio mature.

On the other hand, yield to maturity is not a reliable indicator of returns if the fund manager uses aggressive portfolio management as a technique.

4. Credit risk portfolio

Debt funds are subject to credit risk in addition to interest rate risk. Credit rating agencies rate debt securities based on the issuer’s creditworthiness and ability to repay.

Fixed income securities rated AAA are considered the “best” and have the lowest credit risk. Securities with a poor credit rating, such as a ‘C,’ have a high chance of default.

5. Interest rates

The interest rate regime would greatly influence the attractiveness of debt funds. In a declining interest rate setting, previously issued bonds would have a higher value than newly issued bonds.

As interest rates rise, the value of previously issued bonds declines because investors choose to invest in newly issued bonds with higher rates.

Debt funds offer ease, consistent income, high liquidity, low risk, and relatively predictable returns. The advantage of indexation, which is available after three years for debt funds, allows for tax-efficient investments.