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How to Select Debt Mutual Funds?

An ideal financial plan should be based on the investor’s financial goals and risk appetite. It is important to diversify your portfolio with different asset classes. A Mutual Fund is a fund that invests the pooled money from investors in securities such as stocks, bonds, and short-term debt. Equity, Hybrid, Money-Market, and Debt Mutual Funds are the major types of mutual funds in India. Although debt funds are considered less risky compared to equity funds, they are not completely without risk. If you wish to include the best debt mutual funds in your portfolio, you should understand the various parameters that affect their performance. Even though debt mutual funds park their corpus in relatively safer instruments like government and corporate bonds, investing in them requires a few considerations.

What is Debt Mutual Fund?

Debt Mutual Funds are funds that invest in fixed-income instruments such as corporate bonds, government bonds, treasury bills, certificates of deposits, etc, These are sometimes also referred to as fixed-income funds or bond mutual funds. The fundamental objective of investing in top debt funds is to earn a steady interest income and capital appreciation.

Debt funds are best suited for investors with a short-term and medium-term investment horizon.

  • Short-term Debt Funds: The tenure of a typical short-term debt fund is three months to one year. The best short-term mutual fund is a liquid debt fund which is ideal for parking surplus funds for a short duration. The expected returns are returns in the range of 7%-9% but that is not guaranteed.

  • Medium-Term Debt Funds: These debt funds have an investment horizon of three years to five years. Dynamic bond funds are one of the best debt funds to invest in for this tenure.

Parameters to Consider For Debt Mutual Funds

The best debt or bond fund matches your financial goal and risk appetite. Therefore, before finalizing the top debt funds to include in your portfolio consider these:

  • Maturity of the Fund: Debt mutual funds come with a fixed maturity date. The best debt fund for you would be one that matches your investment horizon. It is advisable to know the average maturity of a debt fund before investing to aim for optimizing returns. Say, you are looking to park your surplus money for a month. A liquid debt fund would be ideal in that case.

  • Interest Rate Risk: Debt or bond funds are not affected by market sentiments but by interest rate cycles. Interest rate risk is the risk of a change in the interest rate impacting the return-generating potential of the debt fund. The lesser the duration, the lesser is the sensitivity to interest rate changes. To minimize this risk, investors can invest in dynamic bond funds. Here, the fund manager manages the portfolio dynamically as to changing interest rates.

  • Credit Risk: Credit risk, on the other hand, is the risk of default when it comes to interest or principal repayment. Thus, it is important to know the credibility of the securities a particular debt fund is investing in. The best debt funds would invest in high-rated AAA or AA instruments. Any debt fund investing a major portion of its assets in corporate bonds is highly risky. Corporate bonds are issued by private companies and the chances of them defaulting are high. The best debt mutual funds wouldn’t have high exposure to Corporate Bonds.

  • Yield to Maturity (YTM): This is the expected return from a debt fund. It measures how much return a fund will generate if the underlying papers are held till maturity. A comparison among its peer debt funds will give you an indication of its performance.

  • Portfolio Diversification: Although diversification is a great way to reduce risk, too many securities held by the debt mutual fund could dilute your portfolio.

  • Assets Under Management (AUM): Mutual Fund companies with large AUM are in a better position to negotiate for better interest rates. Hence, you should invest in debt funds from mutual fund houses with a large AUM.

Conclusion

Any investment should be done according to your risk appetite, investment horizon, and financial goals. An aware investor is a smart investor. A little time invested in understanding the workings of debt mutual funds could potentially generate higher returns for you.

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