How to Choose a Best Debt Fund

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The debt mutual fund category is a happy hunting ground for corporate treasuries, institutional investors and high net-worth folks. This is why retail investors, like us, often feel lost while trying to select the right fund. But here are five steps to choose a good debt fund.

Match your maturity 
Fund houses classify their debt funds into different categories based on the average maturity of the bonds they plan to invest in. This is why the first step to buying a debt fund is matching your own holding period to the fund's maturity profile. Are you looking for a debt fund to park your temporary money (replacement for your savings bank account)?

 Then you must invest in liquid funds or ultra short-term bond funds that typically invest in bonds that mature within three to six months.

If you can hang onto the fund for one to three years, short-term debt funds and short-term gilt funds, which usually maintain portfolio maturities of one to three years, will suit you well. If you are planning on a holding period of three to five years, income funds and credit opportunities funds will be a good fit.

If you have no fixed horizons in mind but can hold on for five years or more, medium to long-term gilt funds, dynamic-bond funds, income funds and credit-opportunities funds may prove a good choice. You can also use any of these categories to take care of the debt allocation in your child's education portfolio or retirement portfolio.

Assess your risk appetite 
Unlike bank deposits, debt funds can suffer temporary NAV losses and wild swings in returns on a year to year basis. Therefore, it is not just your holding period that should decide your choice but also your risk appetite. High returns in the debt-fund category, just like in any other asset class, come with high risks. Therefore, it is important to understand how much duration or credit risk a fund has assumed to make its returns. Duration risk entails holding long-term bonds in the portfolio for capital gains when interest rates fall. Credit risk entails betting on lower-credit-rated corporate bonds to earn higher interests.

Typically, medium to long-term gilt funds, dynamic-bond funds and some income funds take on duration risk to bump up returns. Credit opportunities funds, some income funds, short-term debt funds, ultra short-term debt funds and liquid funds take on credit risk in their portfolios for higher returns. Your decision to take on duration or credit risks will depend on the state of interest rates in the economy. If rates are high, then, after a rising interest-rate cycle, duration funds may pay off as rates fall. If you are close to the bottom of a rate cycle, credit funds can deliver better returns. 

However, both duration risks and credit risks can backfire leading to lower returns. Therefore, it is essential to assess the average maturity of your debt fund's portfolio and its break-up into government and corporate bonds of different ratings before choosing. If you hate bumpiness in your debt-fund returns, liquid or ultra short-term debt funds with safe portfolios (only G-secs and AAA bonds) will be the best choice.

Check scheme track record 
Picking up the fund that is leading in the one, three or five year categories is not the sure shot way to choose a good debt fund. Just like equities, some debt funds are better at navigating bull markets than bearish ones. So, it makes sense to check out a debt fund's track record over two complete interest-rate cycles to assess its performance.

Today, looking back at an eight-year track record for a debt fund would cover two rate cycles. In this eight-year period, 2008, 2014 and 2016 were big bull years for bond markets, and 2009 and 2013 were bearish years. Assess if a debt fund has fared better than its peers in both the phases. Another shortcut to assessing both its track record and risk profile is to take stock of its best and worst one-year performance in the last eight years to 10 years if track records are available. The difference between the two numbers can provide a good approximation of the risk-return trade-off you're taking with the fund.

Watch the expenses 
While the last three years have seen debt funds deliver exceptional returns, the 10 year CAGR across different categories of debt funds ranges between 7.5 and 8.5 per cent. This is why the annual expenses you incur on your debt fund can make a big difference to your returns. Assuming a debt fund owns a portfolio with an average yield of 8 per cent today, over the next one year, a 1 per cent expense ratio will reduce your effective returns by 12.5 per cent a year. But a 2 per cent expense ratio will take away a fourth of your returns.

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