Are you a new investor looking to invest in mutual funds? You may have learnt there are three broad types of mutual funds – equity, debt and hybrid funds. Out of these, debt mutual funds can be quite complex to invest in. There are 338 debt funds in the Rs. 24-trillion Indian mutual funds industry which can perplex you even further, especially if you are a novice.
This article presents a guide on how to select the right debt funds for your investment portfolio.
What are debt funds?
A debt fund is a type of mutual fund which invests a majority of its assets in fixed-income securities such as certificates of deposits, sovereign securities, corporate bonds and commercial papers. It offers a fixed interest income and capital appreciation and carries a low to moderate risk as compared to equity mutual funds.
Factors to keep in mind for choosing the correct debt fund
No one-size-fits-all approach can be applied to declare a debt fund right or wrong. It depends on how well it can meet your individual investment objectives while taking care of your risk appetite. Here are some key parameters that can help you assess if a debt fund is suitable for you.
- Identifying goals
Before you invest, analyse your financial goals on the money you are investing. Is your objective to receive long-term capital appreciation or supplement your current income? Are you looking to use the money to pay for your college expenses or to fund a retirement that could be a few years away? A debt fund with a three-year time horizon works differently as compared to a three-month investment horizon. Higher the duration of the scheme, higher is the interest rate sensitivity. Consider such debt funds that can help you meet your objectives.
- Risk tolerance
Are you a conservative investor or are you comfortable with a moderate degree of risk? Risk and returns are directly proportional. If you are risk-averse, you can consider government bond funds as the risk of defaulting here is the least. Else, you can invest in corporate debt if you are ready to take on the accompanying risk of debt funds. By choosing a dynamic plan, you can give your fund manager a higher discretion to switch maturities to get you the best returns.
- Fund performance
Fund houses deduct something known as ‘total expense ratio’ (TER) from your returns as fees towards managing your investment portfolio. This includes charges incurred by them such as administration, transaction fees, marketing, and so on. The TER ranges from 1.5% to 2.25% and gets charged on a daily basis to your net asset value. It is a wise choice to look for debt funds with the lowest TER so it does not reduce your returns. However, you may also compare the returns of the debt and its consistency before selecting it and not solely rely on the TER.
- Fixed maturity plans (FMPs)
FMPs are closed-end debt schemes that have a fixed maturity. If you plan to invest in an FMP, it is better to stay invested until its maturity even though all FMPs are listed on stock exchanges and allow premature withdrawals. But liquidity in these instruments on the stock exchanges can be low. So, invest in an FMP only if you are sure you will not need the funds until it matures.
Picking debt mutual funds based on their recent returns is tempting. But if you are keen to invest in debt funds which are worthy, you may want to consider all the parameters discussed above before the final selection.