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7 Mistakes to avoid before choosing a Debt Fund

We understand the importance of asset Allocation and we all know that debt fund is an integrated part of it. Many a times due to lack of thorough understanding we are not able to use debt fund as a catalyst in our portfolio. We have tried to simplify the concept so that we can understand and use the appropriate fund at the right time.

(A) Types of Debt Instruments

Debt Fund - Types of Debt Instruments

To know in detailed about the types of debt Mutual Funds visit Types of debt funds.

(B) Factors that determine bond prices

Debt Fund - Factors determine bond prices

(i) Credit Risk

Credit rating agencies assign credit ratings to bond issuers and to specific bonds. A credit rating can provide information about an issuer’s ability to make interest payments and repay the principal on a bond. In general, the higher the credit rating, the more likely an issuer is to meet its payment obligations at least in the opinion of the rating agency. If the issuer’s credit rating goes up, the price of its bonds will rise. If the rating goes down, it will drive their bond prices lower.

(ii) Interest rate

The prices of bonds with a longer term to maturity are more sensitive to changes in interest rates. Prices of bonds with longer maturities will decline by a larger magnitude as compared to bonds with shorter maturities when interest rates rise. Similarly, prices of bonds with longer maturities will rise by a larger magnitude as compared to bonds with shorter maturities when interest rates decline.

(iii) Macro Economic Factors

Economic growth, typically measured by a rising GDP, is bullish for corporations as it leads to increased revenues and profits for companies, making it easier for them to borrow money and service debt, which leads to a reduced risk of default and, in turn, lower yields.

However, extended periods of economic growth lead to inflation risk and upward pressure on wages. Economic growth leads to increased competition for labor and diminished excess capacity.

(C) Things to Check before Choosing a Fund

Debt Funds - Things to Check before Choosing a Fund

(i) Concentrated Risk

Concentration refers to the proportion of holding in one specific bond, higher the concentration in a particular security, higher the risk. For example, if you hold a 10 per cent exposure in a single security and if it defaults, the NAV (net asset value) of the fund would fall to that extent.

The fund manager also has to ensure the scheme is liquid to the extent that the fund has the ability to move in and out of a scheme without impacting its value or price. He ensures the scheme is liquid to manage large redemption without having an impact on its current NAV.

(ii) Returns

Debt Fund - Returns

A debt fund earns in two ways. First, interest payments from its bond holdings generate coupon or accrual income. Second, when interest rates change, bond prices move in the opposite direction, resulting in capital gains or losses on the fund portfolio. When market yields go up, bond prices decline and the value of the fund declines. When market yields fall, bond prices increase, and the value of the fund goes up.

(iii) Credit Rating

Debt Fund - Credit Rating

Credit ratings are just as important for bonds. Highly-rated bonds are more liquid and considered safer than lower-rated bonds because their risk is considered low. More investors are willing to purchase top-rated bonds compared to bonds with lower ratings. It is always advisable to check the mutual fund portfolio rating before investment to understand credit risk.

Returns can be enhance by lowering credit quality of the portfolio which enhances the credit risk.

(iv) Average Maturity of the Fund

Debt Fund - Average Maturity

Debt securities have a fixed tenure and mature at the end of the tenure. At the end of tenure, the bondholder or investor gets back the principal and interest in full. Since debt funds invest in multiple debt securities, it can be difficult to check each security’s maturity. Instead, we can just check its average maturity. You need not calculate the average maturity of a debt fund, it is already available in the factsheet.

Average maturity is the weighted average of all current maturities of the securities in the debt fund. The weight is the percentage holding of each security in the fund. This tells the average time taken for all the securities to mature in the fund.

(v) Modified Duration

Debt Fund - Modified Duration

Modified duration measures how much the price of the fund changes due to a change in the interest rate or yield to maturity (YTM). YTM is the potential returns of a debt fund. The higher the YTM, the higher the return, but the underlying portfolio might be of lower quality, indicating a high risk.

Modified duration follows the concept that bond prices and interest rates are inversely related. It tells how much the change in the interest rate will change the value of the fund. In other words, it tells the effect of a 1% change in the interest rate on the price of the fund. For example, if the modified duration is 3 years, a 1% fall in the interest rate will lead to a 3% increase in the bond price.

(vi) Portfolio Liquidity

A large percentage of corporate debt in the portfolio does not bode well in the short term, as it is relative less liquid. If fund faces redemption pressure, it would be forced to sell these securities at a discount, lowering the NAV. Also, beware of funds that hold a lot of unrated and unlisted debt.

(vii) Avoid schemes with small corpuses

Funds don't disclose if there are any investor who owns a substantial chunk of outstanding units. If there are such investors and they decided to redeem their holdings, the fund could be forced to sell its holdings below the market rates.

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Disclaimer: The report only represents the personal opinions and views of the author. No part of the report should be considered a recommendation for buying/selling any securities. Thus, the report & references mentioned are only for the information of the readers about the industry stated

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