Investing in a debt fund is a great bet if you are planning to play safe with your investments as the funds under this type of mutual funds are invested in government bonds and securities. Thus enabling the investor to earn a fixed income without worrying too much about the risks involved. Though this looks like an investment vehicle that lets an investor earn a good sum of passive income without spraying much mud on themselves, it does have its own set of drawbacks and other things that deserve consideration. This blog will talk about such things which you must consider before investing in debt mutual funds.
Expense Ratio: The expense ratio is the sum of all the costs associated with running the debt fund scheme. Because the returns or upside in debt funds is limited, the expense ratio is more important than in equity mutual funds. A direct plan should be the preferred option for investors with a low expense ratio. Investors should calculate the returns from a debt fund after factoring in the expense ratio. For example, if the return on a debt fund is 9 percent and the expense ratio is 1.5 percent, the investor will only receive 7.5 percent.
Maturity and Duration: Debt mutual funds are more susceptible to changes in interest rates. Bond prices and interest rates have an inverse relationship in general. Modified duration is simply a debt fund’s price sensitivity to changes in interest rates. It demonstrates how changes in interest rates affect the NAV of debt funds (net asset value). The longer the modified duration, the more sensitive the debt fund is to changes in interest rates, and vice versa.
This means that debt funds with a longer modified duration outperform in a falling interest rate environment, while debt funds with a shorter modified duration outperform in a rising interest rate environment. Longer duration funds have higher volatility than shorter duration funds. As a result, both the maturity and duration of a debt fund are important.
Yield to maturity: A debt fund’s yield to maturity is the expected rate of return if all of the securities in the fund’s portfolio are held until maturity. A debt fund, for example, has a yield to maturity of 9%. If the portfolio remains constant until all of the holdings in the portfolio mature, the investor will earn a return of 9%. However, if the fund manager employs active portfolio management as a strategy, yield to maturity will not provide a definitive indication of returns.
If you invest in short-term debt funds with maturities of less than three years that use an accrual strategy, you must consider the yield to maturity as well as the credit ratings of the underlying securities in the portfolio.
Interest Rate Regime: The interest rate regime will have a significant impact on the appeal of debt funds. In a falling interest rate environment, the value of previously issued bonds will be greater than the value of newly issued bonds.
In the event of rising interest rates, the value of previously issued bonds will fall as investors prefer to invest in newly issued bonds with higher interest rates. Because debt mutual funds invest in bonds, they typically outperform in a falling interest rate environment because the existing bonds in the portfolio have a higher coupon rate. As a result, when choosing a debt fund, it is critical to consider the current interest rate regime as well as other factors.
Credit Risk: Debt funds are subject to credit risk in addition to interest rate risk. Credit rating agencies assign ratings to debt securities based on the issuer’s creditworthiness and ability to repay.
AAA-rated fixed income securities are considered ‘highest’ and have a low credit risk. Securities with a low credit rating, such as a ‘C,’ carry a high default risk. Hence, it’s crucial to check the credit ratings of each portfolio constituents of the debt fund. A portfolio that constitutes fixed income securities that are highly rated is ideal to invest in.
Weighted Average Maturity: A debt fund invests in a variety of debt instruments with varying maturities. These maturities determine whether the fund is short-term, medium-term, or long-term.
The weighted average maturity is calculated by taking into account the maturity period of an asset held by the fund as well as the weightage of that asset in the fund’s total assets. Funds with a higher weighted average maturity can provide higher returns due to their ability to hold for a longer period of time. Long-term funds, on the other hand, carry a higher risk due to interest rate fluctuations. As a result, there may be more fluctuations in the fund’s NAV.
Assets Under Management: AUM is the market value of a mutual fund’s investments. Debt mutual funds rely heavily on AUM to manage returns and dividends paid to investors. A debt mutual fund with a large fund size or more assets under management is better positioned to spread fixed fund expenses among its investors. A large fund size translates to a lower expense ratio per person.
Conclusion: One more important factor to consider before investing in a debt mutual fund is the platform you are going to be using. Infini MF from Tradeplus is one of the finest digital platforms for investing in debt funds as well as other mutual funds. If you want to know more about mutual funds, you can go through our pre-made education module.