Ajay Kumar Gupta explains why it is important for investors to select the right product according to their specific investment needs, risk appetite and investment tenure
Fixed income or Debt funds offer a 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 risks in debt funds.
Interest rate risk
Bond prices and interest rates have an inverse relationship. As interest rates rise bond prices fall, and vice versa.
Different fixed income instruments have varying price sensitivities to interest rate changes. The longer the duration of an instrument, the higher is the sensitivity to interest rate changes.
Credit risk
The failure to pay interest or 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 ratings to instruments.
If the 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 may be temporary while credit risk can be permanent
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.
AMCs (asset management companies) disclose the credit rating profile of assets for all their fixed income funds in their monthly factsheets.
You should refer to these monthly factsheets to understand the credit quality of the fund before making investment decisions.
Selecting funds based on investment tenure and risk appetite
As mentioned earlier, investment tenure influences your risk capacity. You should always try to match the duration profile of your investment with your investment tenure.
Debt funds are available for all durations: From 1 day (overnight fund) to 7+ years (long duration fund).
For investment horizon of 1 to 3 months investor can look at investing in liquid funds.
For a slightly longer investment horizon of up to a year, investors can choose money market and low duration funds which provide higher accrual.
Beyond a year, corporate bond funds and banking PSU debt funds with high quality portfolios are ideal as besides high accruals they also provide potential capital gains.
Investors who have a permanent allocation towards fixed income and do not want much duration risk should choose short term bonds funds with high quality portfolios.
For tactical calls on interest rates, investors can choose gilt funds and dynamic bond funds that match their risk profile.
Benefits of debt mutual funds
A debt mutual fund investment offers diversification, better liquidity as investors can easily withdraw their investments at any time.
Investors can also make partial withdrawals if needed. The process of redemption in the case of mutual funds is easier.
Investors can exit at their discretion without having to pay a penal interest /charge.
Conclusion
Interest rate in last one year has moved by approximately 300 bps (3 per cent; 100 basis points = 1 per cent). With most of the rate hikes behind us and expectation of prolonged pause and attractive portfolio YTM's (yield-to-maturity) debt funds could provide attractive returns to fixed income investors as the bond portfolio could generate additional gains in form of bond price appreciation.
Ajay Kumar Gupta is chief business officer, Trust Mutual Fund.
Disclaimer: This article is meant for information purposes only. This article and information do not constitute a distribution, an endorsement, an investment advice, an offer to buy or sell or the solicitation of an offer to buy or sell any securities/schemes or any other financial products/investment products mentioned in this article to influence the opinion or behaviour of the investors/recipients.
Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
