Picking a debt Mutual Fund is typically more complicated than selecting equity funds. Understanding credit risks and tracking interest rate fluctuations are difficult tasks even for seasoned investors.
However, keeping the right pointers in mind ensures that one is well versed with the many variables that go into selecting the right debt fund for any portfolio.
The investment horizon determines the return and risk exposure of an investor thus aiding in selecting an appropriate asset class.
A liquid scheme is ideal to park money for a few days or weeks, and an ultra-short-term bond fund is the right fit for a few months.
For a longer tenure such as a year or two, a short-term fund can be used to manage money. For a period of three years or more, long-term debt schemes are considered stable instruments.
Modified Duration and Average Maturity
The value of a bond has an inverse relationship with the interest rate. If the interest rate rises, the value of the bond falls to match the current yields, thereby decreasing the fund’s Net Asset Value (NAV).
There are two key parameters, namely Modified Duration and Average Maturity, which represent the sensitivity of a debt fund portfolio to interest rate movements. The Modified Duration is the measurement of a bond’s sensitivity to fluctuations in interest rates and it is in years. The Average Maturity determines the average time involved in the maturity of all assets in the portfolio.
The longer the Modified Duration, the more sensitive the fund is to a change in interest rate. Similarly, the higher the Average Maturity, the greater the interest rate risk on the portfolio.
An investor can use both these variables to isolate the overall category of debt funds to find the one that matches his investment goals.
Once the preferred group of debt funds is identified, it is prudent to compile the debt holdings, consequently taking a call on the fund’s overall credit quality.
For important goals, it is best to stick to high quality debts issued by banks and PSUs. If one has an appetite for risk, corporate debt can be included in the portfolio. However, it is always reasonable to stick to funds that predominantly carry ‘AAA’ securities in their portfolios.
As with any fund, it is important to note the fund objective and investment strategy, typically available in the scheme document. It is especially critical to make sure that the Modified Duration and the Average Maturity will more or less remain stable for the investment tenure one has in mind.
While debt funds are great instruments to manage investor wealth, investors should leave no stone unturned to identify the perfect fund that is an ideal fit into their portfolio.