Here’s a guide on how to choose the right debt fund for your portfolio

There are 338 debt funds in the Rs 24-trillion (Rs 24 lakh crore) Indian mutual funds industry. Another 843 of these are fixed maturity plans (FMP). There are 16 different categories of debt funds. Even if you leave out all the FMPs since they are closed-ended (mind you, there are scores of FMPs launched every day, especially towards the end of a financial year), picking the right debt fund is like picking a needle from a haystack.

The on-going crisis in debt funds — where some of their investments, like those in Infrastructure & Leasing Financial Services went bad and other investments in Essel Group companies, Dewan Housing Finance (DHFL) and select Anil Dhirubhai Ambani Group (AGAG) companies came under a cloud — has made them turbulent.

Here’s a guide on how to pick the right debt fund.

Match your duration with investment horizon

While equity funds are meant for long – term investments, debt funds cater to those who wish to invest anywhere between a month and up to 3-5 years. A debt fund that caters to a 3-year time horizon works differently from another that is meant for a month’s investment horizon.

First ascertain for how long you’d like to stay invested in your debt fund. Then, seek out debt funds that are suitable for such tenures. Here’s why.

Higher the scheme’s duration, higher will be its sensitivity to interest rates. A scheme’s duration, when matched to your investment horizon, aims to match its return profile with your investment tenure.

A good measure to look at your fund’s sensitivity to interest rates is its modified duration. Most fund houses disclose this in their monthly fact sheets. This number will tell you how much your debt fund would get affected if interest rates (your bond fund’s yield) were to move up or down by 1%.

Assume your bond fund has invested in a 5-year bond with a face value of Rs 1,000 and a coupon (interest rate) of 8%. If this fund’s yield to maturity is 10%, then back of the envelope calculations show that its modified duration comes to 3.98.

In simple words, it means that if interest rates go up by 1%, the bond fund’s net asset value will fall by 3.98%. Or, if the fund’s yield falls by 1%, the bond price will rise by 3.98%. Higher the modified duration, the more volatile your fund is, because its impact on change of interest rates will be high. Typically, long-term bond funds have a higher modified duration and vice versa.

Select categories with care

Once you select your time horizon, sift through the 16 categories of debt funds. Don’t baulk at the number of categories; there’s logic in it. In 2018, the capital market regulator, Securities and Exchange Board of India (SEBI) told all mutual funds to re-classify all their existing debt funds, and future launches as well, into these 16 specific categories.

Each category was given a boundary within which all schemes must work. Schemes like low duration funds, short duration funds, long duration funds and so on come with restrictions of how short-term or long-term scrips they could invest in. Others like credit risk and corporate bond funds come with restrictions on the credit rating of underlying scrips.

Nithin Sasikumar, co-founder and head-research, Investography, a Bengaluru-based wealth management firm has a tip. “Everyone seeks returns. nobody focusses on risk. Unless you understand intricacies of debt funds- like credit risk and even interest rate risk- avoid picking risk-oriented funds and stick to funds with quality and low average maturities.”

Do you want returns or safety?

Debt funds, like all mutual fund schemes, have certain risks attached to them. That’s not such a bad thing, but if you wish to earn higher returns, you should be able to tolerate risk. How much risk are you willing to take?

The recent debt fund crisis has brought out the risks in debt funds. Again, risk is not bad. But how much risk are you willing to take is the question. Some experts say equity funds should be meant for risk-taking (to earn the returns kicker), while debt funds should be used for parking.

D Muthukrishnan, a Chennai-based certified financial planner, spreads his clients’ money across equity and debt funds depending on their asset allocation. When it comes to debt funds though, he prefers only liquid funds.

“Debt funds are meant to store money. Equity funds are meant to enhance the capital. Hence, there should be no, or at worse, negligible, loss in debt funds,” says Muthukrishnan. He adds that in 2013 when interest rates spiked suddenly, all debt funds’ NAVs fell sharply, but liquid funds recovered “quickly, within two months.”

If you want returns from debt funds, make sure you’re ready to take on the accompanying risk.

Choose FMPs with care

Fixed Maturity Plans (FMP) are closed-end debt schemes that come with a fixed maturity. They invest in debt securities that mature around the same time as the FMP. It pays to stay invested till maturity, though all FMPs are listed on stock exchanges to allow for premature withdrawals. But there’s hardly any liquidity on stock exchanges, which makes the case for investors to stay invested till maturity. That is also many FMPs’ aim to invest in slightly high-risk scrips to get a kicker in returns.

For instance, UTI-Fixed Term Income Scheme – Series XXVI – VII (1,155 days), a FMP that opened on 25 February 2019 and closes on 11 March, will invest its entire corpus in AA-rated instruments (non-convertible debentures or NCDs, specifically) as per its scheme information document.

On the other hand, UTI-Fixed Term Income Fund – Series XXXI – VI (1167 days), a FMP that opened on 13 February 2019 and closes on 27 February, will invest its entire corpus in AAA-rated NCDs, as per its scheme information document.

“FMP is no longer a product that you can invest in it and then forget about it. You also cannot, therefore, afford to invest in a FMP with eyes shut, thinking all FMPs look alike. The SIDs clearly mention where they will invest. Read that information and then decide if that FMP is suited to your risk profile,” says Deepak Chhabria, chief executive officer, and director, Axiom Financial Services.

Should you buy direct plans?

And we thought debt funds are simple and they are a step above fixed deposits. Let’s face it — debt funds are complicated. Some of the instruments, like loan against shares, that some debt funds have been found investing in, are complex.

Roopali Prabhu, head of investment products, Sanctum Wealth, said: “Several investors who had invested in direct plans of some of these schemes without a guiding hand would be at a loss today. Debt funds are complex to understand and having an advisor helps.”

It’s okay to invest in direct plans to save costs. But only if you understand mutual funds, investing and financial planning. Else, get an advisor/distributor who understands technicalities and nuances of fixed income investing.