We often find ourselves talking about how to choose Equity based Mutual Funds and which Equity Funds are best for long term Investments. However Debt based Mutual Funds are also equally important while constructing a well diversified investment portfolio. A study conducted about returns from different asset classes showed that proper asset allocation plays a major role in the overall returns generated by a portfolio. Also the Assets under Management (AUM) of Debt based Mutual Fund schemes is much larger than the AUM of Equity-based Mutual Fund schemes. So let us quickly look at the factors to consider while choosing Debt based Mutual Funds.
1. Tenure: The first factor we must consider is the tenure for which we intend to stay invested. So when will we need the money, is the question we need to answer. If we won’t need the money for five years or more than its better to take a little risk and invest in Large Cap Equity Funds or Hybrid Funds. But if we are going to need the funds within the next five years than it’s best to invest in Debt Funds. The type of debt fund we should choose depends on exactly how long we intend to stay invested. So if your investment horizon is two or three months, you should opt for liquid funds or ultra short duration funds. If your investment horizon is a year you should opt for money market mutual funds. If your investment horizon is two or three years you should consider short duration funds and for investment horizon of three to five years you can look at medium duration funds. Also you can consider cascading or laddering your debt fund investments into mutual fund schemes holding bonds with different maturities inline with your investment horizon.
2. Credit ratings of the Schemes portfolio: It is of paramount importance to ensure that the bonds and other credit instruments held by the scheme have the best possible credit rating given by CRISIL, CARE, ICRA etc. It is not wise to invest in credit risk funds in my opinion. Investments in such funds may result in headaches and loss of principal. It is wise to avoid the temptation of a few extra points of interest, to protect ourselves from financial loss and anxiety.
3. Portfolio Concentration: Investors must ensure that the mutual fund scheme’s portfolio is well diversified. A good practice is to invest only in schemes which don’t have an exposure of over five percent to any single issuer of securities. Diversification reduces the intensity of loss just in case there is a default by one or two debtors.
4. Expected Interest Rate Changes: Depending upon the current and expected rate of inflation in the economy, the investor can anticipate the direction of interest rates in the country. If inflation is high, interest rates are likely to move northwards and vice versa. It is good practice to invest in short duration funds with modified duration of one or two years during periods of low as well as high inflation unless you know how to predict interest rate movements.
I hope this article is able to guide you through your investments in debt funds.
