How to choose a Debt Mutual Fund?

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In the current scenario, when fixed deposits are providing paltry interest rates, many savers are desperately looking for alternative investment avenues that come with lower volatility, a reasonable degree of safety and higher post-tax returns. Due to its tax efficient structure, debt mutual funds are rapidly gaining prominence among Indian investors.

Debt Mutual Funds vs Fixed Deposits

Despite its huge potential, many investors are unaware or do not know how to choose a debt mutual fund for investment.

Important factors to keep in mind before selecting debt mutual funds are investment horizon, net yield to maturity (YTM), interest rate scenario, portfolio structure, debt security selection process, risk management framework of the fund house and the performance track record.

Let’s see the importance of each factor:

1)       Investment Horizon: Ideally one should select a debt mutual fund portfolio with an average maturity matching with the investment horizon. That means for funds required anytime within 1 year, the investment should be done in liquid/ultra short-term funds. Similarly, if the investment horizon is more than 3 years, funds with portfolio maturity close to three years should be selected. The reason for this is to avoid mark-to-market losses at the time of redeeming the funds.

2)       Net Yield to Maturity (YTM): YTM of a debt mutual fund scheme gives a rough idea of how much return one can expect if he holds the fund for a period similar to the average maturity of the debt fund portfolio holdings. Net YTM is YTM minus fund expenses (also known as expense ratio). It is important to know net YTM and not just gross YTM. The expense ratio of direct plans of mutual funds will be lower than the expense ratio of regular plans of mutual funds. Consequently, the net YTM of direct plans would be higher compared to regular plans.

3)       Interest rate scenario: If you can make a good guess of the movement in interest rates over your holding period, you can earn higher returns than others on your debt mutual funds. In a declining interest rate scenario, debt portfolio with higher average maturity earns a better return due to mark-to-market gains. Similarly, it is advisable to invest in a portfolio with lower average maturity in a rising interest rate scenario to minimize mark-to-market losses.

4)       Portfolio Structure: It is important to understand that a portfolio is well balanced in terms of the quality of debt securities that it is holding. A portfolio with a high concentration in securities with low credit ratings should send a warning sign. Also, there should not be a high concentration in a few debt securities.

5)        Investment Philosophy & Process: A robust and clearly defined investment philosophy & process of a fund house is non-negotiable for a debt security selection. This reduces the risk of getting overwhelmed by emotions at market extremes. An in-house credit analysis team with strong credentials provides confidence that fund house is performing the due diligence on its own and not just totally dependent on external credit rating agencies.

6)       Risk Management Framework: When an even small percentage of returns become important in debt funds due to their lower return potential compared to equity mutual funds, any major default in any holding could impact returns leading to a bad taste for investors. Therefore, risk management framework forms the core of successful debt fund management. Various measures like a highly diversified portfolio, liquidity, diverse set of investors, higher AUM size, collateral and credit lines from banks etc. are some of the measures employed by fund managers to mitigate any risk.

7)       Performance Track Record: Ability of fund manager to generate higher returns in changing interest rate trajectory and market scenario. Although this provides confidence in the fund manager’s ability to navigate through various market scenarios, the past returns should be seen in the context of the overall market scenario and should not be extrapolated for future returns.

The above-mentioned particulars for debt fund selection would ensure that you select a debt fund scheme that is best suited to your requirements.

Truemind Capital is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at connect@truemindcapital.com or call us on 9999505324.