After we posted an article on our website titled Should you invest in a debt fund or buy bonds?, a number of readers wrote in for advice on how to select a debt fund. Somehow, it appears to be a more daunting search than that for an equity offering.
Follow these basic parameters and you will be on solid ground.
Step I: The starting point is you
What is your investment horizon? The very nature of equity, as an asset class, demands that investors go into it with a long-term perspective in mind. Not so in the case of debt funds which range from short to intermediate to long maturities.
If you need to park your cash for just a few months, there are ultra-short term or liquid funds to look at. Short-term funds are for those who would like to invest for a period ranging from one to three years. For periods beyond, there are intermediate and long-term debt funds.
Step II: Consider the interest rate risk
While debt funds are not as perilous as equity funds, they are not without their share of risks—the most prominent being the interest rate risk.
The interest rate risk refers to a change in the price of a bond due to the change in the prevailing interest rate. As interest rates rise, bond prices fall and vice versa. The higher the maturity profile of a fund’s portfolio, the more prone it is to interest rate risk. So in a rising interest rate scenario, opt for funds with lower maturities. The reverse in a falling interest rate scenario.
Step III: Check what's propping up the return
You may find a fund with an exceptional return when compared to its peers. Curb your enthusiasm. Take a good look at its portfolio. Each debt instrument is assigned a credit rating. Higher the credit rating of the fund’s underlying instruments; less exposed the fund would be to credit defaults.
Credit risk refers to the credit worthiness of the issuer of paper-- either a corporate or financial institution. Credit risk takes into account whether the bond issuer is able to make timely interest payments and repay the principal amount on maturity. A firm with a low credit rating often compensates investors by offering a higher return. So if the fund is delivering admirably, do check to see if the reason is due to a portfolio packed with relatively riskier instruments. Government bonds, incidentally, are sovereign backed and have the highest rating in terms of safety.
Moreover, if the fund manager invests in poorly rated paper, this could turn into a liquidity risk. A fund faces liquidity risk if the fund manager is not able to sell his paper due to lack of demand for that particular security. Liquidity risk is high in funds with a low credit quality portfolio
For a more detailed treatment on the risk of debt funds, read Are debt funds really risk free?
Step IV: Size does matter
Fund size does gain some significance in the case of debt funds because the flows are normally of a substantial size. Also, trading in the debt market requires huge minimum lots. A well sized debt fund would enable the manager meet redemptions without resorting to distress sales and also give him sufficient assets to trade with.
Step V: There is a cost
Check out the expense ratio and the exit loads. Since returns from debt funds are typically lower when compared to those of equity, high expenses could make a huge dent on the returns. Various debt funds levy an exit load if investments are redeemed before a specified period to deter short-term outflows. Keep this in mind when investing.
And finally, don’t forget to look at returns. Don't opt for a dud even if it fulfills all the above criteria.
All the above data —expense ratios, performance, size of funds, and quality of portfolio, is accessible and can be viewed on the Morningstar website.