When To Invest In Debt Funds: Things To Know Before Investing In Debt Funds
This blog will help you identify the right debt mutual funds for your portfolio. You will learn how to pick debt funds and what needs to be taken into consideration while investing in debt mutual funds.
June 21, 2021
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Investing in debt funds usually gives you benefits like solid returns and tax efficiency. However, there are more debt scheme variations in the market than there are states in India. So, picking good debt funds isn’t really that easy.
To make matters even more complicated, TV ads keep telling you “mutual funds sahi hai” but nobody tells you “kaunsa mutual funds sahi hai”. It’s quite natural to find yourself in a pickle keeping all of this in mind.
If you’re wondering the same thing you’ve come to the right place! Let’s simplify all the complex jargon that the finance industry uses and get you one step closer to picking the right debt mutual funds.
#1. Expense Ratio
Expense ratio is a fee charged by the fund management team for their services. It is generally expressed as a percentage and is charged when you exit the debt fund.
The expense ratio varies based on the level of involvement of the fund manager and their associates. Broadly speaking, it’s based on:
A. Active Management
A fund manager is involved in the day to day operations (buying and selling debt securities) in an actively managed fund. The expense ratio for such debt funds is generally higher because of the active approach.
B. Passive Management
A passively managed fund doesn’t require the constant attention of a fund manager and their team. It’s generally on autopilot for the most part and hence, the expense ratio tends to be generally lower.
A higher expense ratio can eat into your returns and that’s something most investors would want to avoid. Thus, you must pay attention to the expense ratio charged by the debt fund before investing.
Maturity simply means the time it takes for a debt fund to get its principal amount back. We’ll use the example of bonds here because that’s one of the most common securities that a debt fund holds.
A borrower issues a bond to a lender when they take out a loan. The bond is issued for a fixed duration of time and carries an interest rate that is periodically paid by the borrower.
The bond can be issued for the short, medium, or long term based on the borrower’s needs and repayment ability. Generally, a long duration bond is known to carry more risks than short duration bonds.
Logic states that the chances of defaulting on a 1-month loan are lower than a 10-year loan because a lot (good and bad) can happen over the long term like interest rate tightening by the RBI.
So, knowing the duration of the securities held by a debt fund can help you measure the risk involved. But it’s important to know that most top debt funds do a thorough credit analysis before investing in bonds.
And if you’re investing with an app like Cube, you’ll have access to top-notch investment advice from Wealth First, industry experts who have a track record of beating Nifty by ~50% over the past decade.
#3. Yield To Maturity
The term yield to maturity (YTM) means the expected returns received when the bond matures. For example, it’s the expected return received at the end of 10 years on a 10-year bond. But that’s just for one bond.
We’ve spoken about how debt funds invest in many bonds. What to do in that case? Simple, the YTM of a debt fund is the weighted average of the yield generated by all the bonds in its portfolio.
A higher YTM means that the debt fund is riskier than one with a lower YTM. The inference is that poor grade bonds carry a higher coupon rate because of low credit rating. This bumps up the risk.
However, you must also keep in mind that a change in a single bond’s yield can have a drastic impact on the YTM of a debt fund. In any case, this is a useful metric to keep an eye on when investing in debt funds.
The desirability and returns of a debt fund are correlated with the RBI’s interest rate regime. Bonds are issued at a fixed interest rate known as the coupon rate. This is different from the RBI’s interest rate.
Bonds, and by association, debt funds, have been known to gain value when the interest rate falls below the coupon rate. The reverse is true and debt funds tend to lose value when interest rates rise above coupon rates.
Thus, Investors must keep a keen eye on the RBI’s interest rate changes. Honestly, different debt funds employ different strategies to counter interest rate changes.
For example, a dynamic bond fund tends to pivot between short and long duration bonds based on the interest rate changes. However, not all debt funds have that privilege.
The majority of a debt fund’s portfolio is invested in debt securities that carry a credit rating and by extension, a credit risk. This risk basically implies that a borrower may potentially default on their payment.
Again, top quality debt funds do their best to mitigate this risk with thorough research and analysis. But the possibility still exists, although it is minimal. Investors must thus evaluate the credit risk of each debt fund.
#3 touched on the weighted average yield to maturity of all bonds held by debt funds. While bonds are the primary investment option of debt funds, they represent a part and not the whole portfolio of the fund.
There are other debt and money market instruments held by debt funds that mature at different times. In such a case, you can calculate the weighted average maturity of all the debt fund’s securities.
The calculation will reveal two things:
Risk: long maturity period is riskier than a short maturity period
Returns: long maturity period has a higher chance of being more lucrative than the opposite
Difficult, isn’t it? It all boils down to your risk profile and investment goals. You can move one step closer to investing in the right debt funds by taking Cube’s free risk analysis quiz
#7. Debt Fund Track Record
Historical returns aren’t an indicator of future performance. This phrase may seem overused but it has value… only to an extent. That’s because a fund’s track record can shed light on:
Management team’s quality
Fund’s investment philosophy
Ability to spot winners and losers
For example, a fund that has consistently performed poorly over the last 10 years would have a lower chance of generating stellar returns in the future than a fund that has been steadily beating the benchmark.
Long story short, understanding the past record of a debt fund can help you avoid the catch-22 situation of “every time it’s been the same” but “this time it’s different”.
This makes debt mutual funds a suitable investment for achieving short term investment goals like paying college fees, buying a new mobile phone, etc with relatively better safety than equity funds.
Myth: only conservative investors should invest in debt funds. Fact: debt funds are suitable for most risk profiles. That’s because a debt fund can be used as an effective tool for diversifying an aggressive portfolio.
#3. Alternative To FDs
Bank FDs have been the go-to investment option in India but the FD returns have been dwindling between the range of 4.5-5.5%. Debt funds, on the other hand, have been known to generate 7-9% returns on average.
Knowing these pointers can help you narrow down a list of suitable debt funds for your portfolio. But there’s an alternative to this approach that can be very helpful if you’re a busy professional.
How To Invest In Top Performing Debt Funds In India?
The Cube Wealth app allows you to access top performing debt funds recommended by Wealth First who have over 3,000+ clients and currently manage ₹7,000+ crores in assets.
Experts at Wealth First use 12+ complex qualitative and quantitative metrics to narrow down the schemes and handpick only the best debt funds in India. Here’s how you can start investing in top debt funds:
on stock picking, poring over excel sheets, financial news, analyzing market trends, tracking the Sensex, researching company fundamentals, comparing mutual funds, reading financial reports, trying to predict the future & losing your sanity!