How to Choose the Best Debt Mutual Fund?
Debt mutual funds primarily invest in fixed income securities, which include money market instruments like commercial papers, corporate bonds, treasury bills, government bonds and other instruments.
Comparatively speaking, debt mutual funds carry lesser risk than equity mutual funds but there are two inherent risks with debt funds which you need to take into account. Interest rate risk and credit risk.
Interest rate risk is inversely related with the price of debt securities. If the prevailing interest rates in market increase, then the price of debt securities will fall. The impact of interest rate risk is visible more inherently in long maturity securities as compared to their shorter counterpart. It means funds that invest in long maturity securities are more vulnerable to interest rate change and have more price risk.
Credit risk measures the risk of default on interest or principal payment or not paying on time. You can analyse the credit risk by checking the credit ratings given by credit rating agencies like CRISIL to the debt securities. For example, AAA is considered as the highest rated instrument and risk will increase if you move further down the line like AA+, AA, AA-, A, etc. If a debt fund has most of its investments in high-rated papers then it will have a higher credit rating and thereby a lower credit risk. To avoid the credit risk, Govt securities are the best option as they have least default risk and come with a sovereign backing.
After you’re well-versed with these 2 risks, you need to consider the amount of risk you’re willing to take when you put your money in a debt fund.
If you want your money to be in a relatively risk-free fund, overnight funds and liquid funds may do the trick for you as they come with negligible interest rate risk and credit risk. They’re also good if you ever want to cash out for emergency purposes. Overnight funds are suitable for a short tenure as low as 7 days and liquid funds are good if you’re looking to park your money for liquidity and safety. The investment period for liquid funds could be from 7 days onwards.
If you’re willing to take a little more risk in lieu of slightly higher returns than the previously discussed funds, low-duration funds, medium-duration funds, corporate bond funds may be the fit for you. Low-duration funds are good if you’re looking at an investment timeframe of 6-12 months. And as high-returns come with high-risks, you can choose long-duration funds, credit risk funds, if you can digest the risk, as in a long-term investment timeframe, they hold the potential to yield good returns.
It’s also important to check the fund manager’s history of operating in similar funds and the performance of the fund manager over the past few years and the Asset Under Management or AUM of a fund, which is the total money invested in any particular scheme by all the investors.
On top of all this, ensure that the expense ratio of the scheme you choose should be comparatively low. Mutual funds bear the expenses related to distribution and management fees, which they charge as fees, so a higher ratio may impact your overall returns.
Before we end, let’s take a look at what should be considered while choosing a debt fund:
- Consider the interest rate risk and credit risk before choosing any fund for investment
- Weigh the risk you can take depending upon the investment timeframe you’re looking for and your financial situation.
- Shorter duration funds are suitable for a short period or if you are not willing to take a high price risk.
- You can mitigate credit risk by investing in a fund that invests in high-rated securities or Govt securities.
- Assess the fund manager’s historical performance for the similar funds
- Look for a scheme that has a lower expense ratio.
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