Debt Mutual Funds mainly invest in instruments such as G-Sec bonds, treasury bills, corporate bonds, commercial paper, and few other money market instruments. Most of the debt funds aim to optimize return with a mix of yield, liquidity & security. But no two debt funds are the same. Each can vary widely due to inherent risk – reward matrix.

Generally, all EQUITY investors look very closely at the underlying portfolio and ratios while selecting equity funds, but the same enthusiasm is not shown while choosing debt fund. Though the debt funds are considered less volatile than equity funds, still here are some key aspects to judge before investing in a Debt mutual fund.

Concentration Risk

Concentration risk arises from too much exposure in a particular security(s). Debt funds offer an element of diversification as they generally spread investments across 50-60 securities. So, even if there is a default or credit event in 1-2 issuers (securities), it may not have any major effect on overall portfolio performance, provided the fund was not overweight on the defaulting security.  Investors should carefully analyse the portfolio segregation across securities to see if there is any high concentrate exposure. Special attention needs to be paid to securities issued under different names or from different corporates, but are owned by the same business group. Having large number of securities from different corporate entities, but backed by the same business group shall not make it a diversified portfolio.

Modified Duration

Modified Duration is simply the propensity to change in the value of debt security in response to the change in interest rates. So let’s say the Modified Duration of a bond / fund is 1.80 years. What this illustrates is that the price of the bond / fund will decrease by 1.80% with a 1% increase in interest rates. This provides a fair indication of a bond’s sensitivity to a change in interest rates. The higher the modified duration, the more volatility the bond/fund shall exhibit with a change in interest rates. Investors who don’t have understanding of interest rates cycle should avoid high duration funds as rising interest rate scenario can cause heavy losses in otherwise safe fund holding.

Yield to Maturity

Yield to maturity (YTM) of a debt fund portfolio is the expected rate of return before expenses an investor could expect if all the securities in the portfolio are held until maturity. It broadly indicates to the investor the kind of returns that could be expected. But it is not a sole indicator since returns may vary due to mark-to-market valuations or changes in the portfolio.

Expense Ratio

It is a fee charged by the AMC as a percentage of the net assets under management (AUM) to manage a particular mutual fund scheme. For the same level of performance of the underlying portfolio a scheme with lower expense ratio will give higher returns. Although expense ratio should not be the primary factor in debt fund selection, investors still should look at expense ratios because it can impact investment performance in unfavourable conditions over short investment tenure

Credit Quality of the holdings

Credit quality should be one of the principal criteria for judging the investment quality of a debt mutual fund. As the term implies, credit quality informs investors of a fund portfolio’s creditworthiness or risk of default. Higher the rating, high is the creditworthiness of the borrower, although the returns may be lower as compared to a bond issued by an entity that has a lower rating. The credit profile of the debt portfolio indicates the level of credit risk that the debt fund has assumed.

Summary:

Debt mutual funds are a great investment alternative for investors with conservative to moderate risk appetite. They offer better returns than the traditional bank savings options plus they are more tax efficient. While bank FD interest is taxed as per the income tax slab of the investors, capital gains from debt funds held for more than 3 years are taxed at 20% after allowing for indexation benefits, which reduces the tax liability for investors considerably. DIY investors should consider the above-mentioned factors carefully before investing or better seek professional advice.