Factors to consider before investing in Debt Mutual Funds

Fixed Income or Debt funds offer a greater variety of products across the risk / return spectrum. It is, therefore, important for investors to select the right product according to their specific investment needs, risk appetite and investment tenure. Before we discuss how to choose the right debt fund, we should understand the two main risk factors in debt funds:

• Interest rate risk: Prices of fixed income securities are inversely related to interest rate changes. If interest rate goes up, price decreases and vice versa. Different fixed income instruments have varying price sensitivities to interest rate changes. Price sensitivity to interest rate change is also known as duration. Longer the duration of an instrument higher is the sensitivity to interest rate changes.
• Credit risk: This refers to risk of default i.e. failure to pay interest and / or the principal by the issuer of the fixed income instrument. Rating agencies assess the credit risk of fixed income instruments based on the financial strength of their issuer and assign credit rating to instruments. If credit rating of an instrument gets downgraded, the price of instrument will fall. Likewise, if the credit rating gets upgraded, the price will rise.

Interest rate risk is temporary while credit risk is permanent

Price of a fixed income instrument will fall if interest rate goes up. However, interest rate movements are always in cycles – periods of rising interest rates are followed by periods of falling rates. If you have a long investment horizon, you will be able to ride out the volatility due to interest rate changes. However, if the issuer defaults on interest and maturity payments then the price of the instrument will be written down permanently. Therefore, credit risk is often permanent and investors should aim to minimize this risk.

How will you know the credit quality of your scheme?

AMCs disclose the credit rating profile of assets for all their fixed income funds in their monthly factsheets. You should refer to these factsheets to understand the credit quality of the fund before making investment decisions.

Selecting funds based on risk appetite

Investors should understand that risk and return are directly related. Your returns expectation should be commensurate with the risk profile of your investment. Investors should be aware of the linkage between investment tenure and risk capacity (especially interest rate risk). Shorter the investment tenure, lower the interest rate risk capacity and vice versa.

Very short duration funds like overnight and liquid funds have very low interest rate risk but their average returns are likely to be lower than debt funds with longer duration profiles. Short duration and medium duration funds have moderately low to moderate interest rate risk. Their average returns are usually higher than liquid funds over a sufficiently long tenure but lower than funds which have even longer duration profiles. Dynamic bond fund and Gilt funds have the potential of giving high returns but they can be quite volatile in the short term. You should select funds according to your risk appetite. Funds which invest in lower rated instruments (higher credit risk) can give higher returns than funds with high credit quality profiles because lower rated instruments give higher yields than highly rated instruments. But you should be aware of the risk you are taking. Unlike interest rate risk, which can be mitigated by extending your investment tenure (period of rising interest rates are usually followed by period of lower interest rates), credit risk is permanent - if the issuer defaults, then your loss is permanent. In the current economic environment, credit risk is much more dangerous. You should understand the credit risk of your investment and make informed decisions.

Selecting funds based on investment tenure

As mentioned earlier investment tenure influences your risk capacity. You should try to match the duration profiles of your investment with your investment tenure. For very short investment tenures (few days / weeks / months), you should invest in overnight funds or liquid funds. For 1 – 3 year investment tenures, you can invest in short duration funds or similar funds whose duration profile is less than 3 years. For 3 years plus investment tenures you can invest in dynamic bond funds and Gilt funds.

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