Debt funds provide a range of schemes for a wide variety of risk profiles and investment needs. As discussed in the previous chapter, there are debt funds with maturity profiles ranging from 1 day to 10 years or longer. Depending on the category, the yields of different debt funds can be in a fairly wide range. Similarly, the risk profiles of different category of funds and individual schemes within a fund category can vary a lot. You should make informed decisions and know how to invest in debt funds or how to buy debt funds.

Factors to be considered

The two most important factors to be considered when investing in debt funds are:-

• Investment tenure – How long you plan to remain invested in the scheme? This is a very important consideration because it can help you in selecting the right scheme.
• Risk appetite – There are two kinds of risks in debt funds - (a) interest rate risk and (b) credit risk. We will discuss these two risks in greater details in another chapter. You should invest in the appropriate fund according to your risk profile.

Investment tenure

Bond prices have an inverse relationship with interest rates. Bond prices go up when interest rate falls and vice versa. Interest rate changes will have impact of varying extents on the scheme net asset value (NAV) depending on the fund category. Some funds have low to moderately low volatility, while some may have moderately low to moderate volatility when interest rates change.

If your investment tenure is very short e.g. few days, weeks, months etc., you should invest in debt funds with very low to low volatility. If your investment tenure is long e.g. 3 years or longer, you can invest in funds which have moderate volatility and higher yields. If you have medium term investment tenures e.g. 1 to 3 years, you should invest in the funds of appropriate interest rate risk profiles. For funds of similar credit quality, interest rate volatility increases with duration of the scheme. Your investment tenure should be aligned with the duration profile of the fund – select funds of appropriate durations based on your investment tenures. 

Risk appetite

While investment tenure should have a direct bearing on the risk profile of an investor, types of risk profile can differ across investors based on their financial situation and attitude towards volatility. You should consult with a financial advisor if you need help in knowing your risk profile. If you have low risk appetite, you should invest in debt funds which are less volatile (lower interest rate risk). If you have higher risk appetite, then you can invest in funds which are more volatile (higher interest rate risk).  

You should know that, the usual shape of term structure of interest rates, also known as yield curve, is upward sloping – longer duration bonds and funds usually have higher yields. Therefore, even though longer duration funds can be more volatile in the short term, if you have long investment tenures then you can get potentially higher returns. You should invest in debt funds of appropriate risk profiles according to your appetite. In summary, risk profile management is utmost important while investing in debt mutual funds.

While volatility of debt funds are usually associated with interest rate risks, you should not ignore credit risks. While bonds with lower ratings may give higher yields, you should remember that a credit rating downgrade or default, irrespective of fund category may result in a loss for you. If you want to avoid credit risk, invest in schemes which have high credit quality. You can check the credit quality of a scheme in the fund factsheet.

New Riskometer

SEBI has asked mutual funds to label their schemes according to the new Riskometer, which now has 6 types of risk profiles. One important change in the new Riskometer is the appropriate labelling of scheme level risk, rather than category level risk. In the old Riskometer, risk was labelled at a category level. But within the same category e.g. low duration, different schemes may have different risks depending on the credit rating of their underlying securities. You should always refer to the Riskometer before making investment decisions. You should consult with your financial advisor if you need help in understanding the Riskometer.