Rajguru Rao has been investing in bank fixed deposits for almost 10 years now. Even after investing for close to a decade, he hasn’t been able to earn any productive returns out of it. The reason behind this being a serious slump in the interest rate over the past few years. After learning that there is a possibility of interest rates slashing down further, Navneet began researching for other modes of investing which might help him generate capital appreciation. That’s when he came across debt mutual funds. Rajguru was first skeptical about investing in mutual funds because he felt that he might lose his money to market volatility. But later, he came across a friend who is already investing in mutual funds who suggested Rajguru to do some primary research about various schemes before investing. Rajguru was left confused as he was new to mutual funds and didn’t know how to go about it.
In this article, we will try to focus on how to choose the right debt funds for your financial goals.
Understand the different types of debt funds
Many people will argue that debt funds are less risky than equity funds which is why people can invest in any debt fund. This is not at all true because debt funds invest in various money market instruments and debt securities of different credit ratings. Debt funds that invest in securities with low credit rating are riskier than those which invest in securities with high credit ratings.
For example, a credit risk fund is far riskier than an overnight fund or a liquid fund although both fall under the debt fund umbrella. As per SEBI categorization, here is a list of all the debt funds currently available for investment –
- Overnight funds
- Liquid funds
- Ultra-short duration funds
- Short duration funds
- Long Duration Fund
- Dynamic Bond Fund
- Credit risk funds
- Gilt fund
- Banking and PSU Funds
- Corporate bond funds
How are debt funds different from each other?
There are some debt funds like liquid funds, overnight funds, short duration funds, ultra short duration funds etc. that are far less volatile in nature. Then there are gilt funds, credit risk funds etc. which are far more volatile than the ones stated before. Different debt funds carry different types of risks. Two biggest risks debt funds usually face is credit risk and interest rate risk. Interest rate risk is the risk that is related to the fluctuating interest rates in the market. A sudden increase in the interest rate will cause a decrease in the NAV of a debt fund and vice versa. This shows that interest rate and NAV are inversely related.
How to choose the right debt scheme?
Depending on an investor’s investment objective and income needs, they must decide which mutual fund to invest in. To make the most out of your invested sum, investors are expected to keep a diversified portfolio. If you depend on any mutual fund scheme to achieve your investment goals, you may find it difficult to achieve them. This is why mutual fund experts recommend investors to first understand their goals, investment horizon, risk appetite and only then make an informed investment decision. Do not choose a debt fund solely based on the size of its AUM, its past performance, or its ability to generate high returns. The aim should be to invest in a debt fund that can offer stable consistent returns rather than seeking a top performing fund. Investors are also expected to thoroughly go through the mutual fund factsheet and seek professional consultation before deciding which debt fund to invest in.