How to select right debt fund for investment

It is a common belief that debt funds do not carry risk. But in reality, they carry various risk and one of the most important being the interest rate risk. Interest rate and price are inversely related. If the interest rate goes up bond prices fall and vice versa. Depending upon this risk, debt fund managers have largely two strategies, duration and accrual strategy. In case of duration strategy, fund manager normally invests in long-term debt instruments that are more sensitive to interest rate. 

You as an investor can prefer funds applying any one of the strategies depending upon your risk appetite. Nevertheless, one of the thumb rules is that investors should try and look at an average yield of the 10-year benchmark scrip over the past 8-10 years. As currently, the interest rate cycle in India is around 8-10 years, if the prevailing yield at the time of investment is higher than this average yield, you can invest. The reason being that chances are more that yield will move towards average yield and hence you may earn more as bond prices fall. If you believe interest rate is going to fall, going forward, you may invest in long-term bonds that gain most in case of interest rate falls. However, if the interest rate rises, you may suffer losses in your portfolio. 

In case you are risk averse, funds following accrual strategy suit you. Under this strategy, the fund manager invests in short-term instruments and hence the interest rate risk is lower. The fund manager holds the securities till maturity to reduce the interest rate risk. Currently, when inflation is rising, interest rates are not going to fall as we have been seeing in the recent past. Hence, investing in shorter duration funds that are less prone to interest rate risk is a good choice. 

Next, you should select those funds that generating returns above average, but not extraordinarily high. The reason being investing in debt involves credit risk. Depending upon the financial health of the company, rating agency give ratings to the debt issued by the company. The better the credit rating the safer the instrument is. Hence, a fund giving higher returns might have more exposure to debt instruments that have a lower credit rating. Therefore, before you invest look at the portfolio of the fund and make sure it is not over-exposed to the bad quality of debt.

The size of the fund plays an important role in selecting the right debt mutual funds as liquidity is less in case of the debt market. Therefore, a fund with inadequate size may see its performance impacted in case of huge redemption. Therefore, selecting a well-sized fund helps you avoid such risk.

Retail investors in India are less exposed to debt mutual funds when compared to equity mutual funds. The reason being that they are being less understood and considered complex. But the reality is if you understand debt funds, it can be used wisely to complement your equity portfolio and achieve your financial goals.