What are 5 important factors to look in debt mutual funds: Part 1

It is our endeavour at Advisorkhoj to increase awareness and knowledge about mutual funds among common retail investors. Debt mutual fund is a product category where we perceive a sense of a lack of clarity and understanding based on comments / queries received by us from you. Debt fund investments are not difficult if you understand some of the basic factors which form part of the scheme characteristics.

In this 2 part blog post, we will discuss 5 important factors that you must understand and evaluate when selecting the right debt fund for your own specific investment needs.

Difference between equity and debt funds

Before delving deeper you should understand the basic difference between equity and debt mutual funds. Equity funds primarily invest in equity (stocks) or equity related securities, while debt funds invest in fixed income securities like commercial papers, certificates of deposits, Treasury Bills, Government Bonds (G-Secs), corporate bonds and debentures (NCD). The primary source of returns in equity funds is price appreciation of the underlying stocks in the secondary market (stock exchanges); dividends paid by the stocks are secondary source of returns. The primary source of returns in debt funds is the interest paid by the fixed income security and price appreciation is the secondary source. Since most fixed income securities pay a fixed rate of interest (also known as coupon), debt funds are much less volatile compared to equity funds. That said debt funds also have risks.

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Debt fund risks

• Interest Rate Risk: Price of fixed income security or Net Asset Value (NAV) of a debt fund has an inverse relationship with interest rate changes. Price will rise if interest rates fall and vice versa


• Credit Risk: Price of a fixed income security or NAV of a debt fund has direct relationship with credit rating changes. Price will rise if credit rating goes up and vice versa

You should always keep these two risks in mind when making any debt fund investment and invest according to your risk appetite and financial needs.Without further ado let us discuss the 5 important factors to consider when investing in debt funds.

Did you know how you should invest in debt mutual funds: short term versus long term

Expense Ratio

Expense ratio is the fee charged by the asset management company (AMC) as a percentage of the net assets under management (AUM) to manage a particular mutual fund scheme.For the same level of performance of the underlying portfolio a scheme with lower expense ratio will give higher returns. In our view, expense ratio is a much more important factor in debt funds compared to equity funds because debt fund returns are usually range-bound across different market conditions. In other words, debt fund managers are more constrained in delivering high returns to offset higher expense ratios vis-a-vis equity fund managers who can deliver high alphas.

While expense ratio should not be the only consideration in debt fund selection, investors should look at expense ratios because it can impact investment performance in adverse conditions over short investment tenures. You should look at expense ratios of debt funds if your investment tenure is short, e.g. liquid funds, ultra-short duration funds, low duration funds, money market funds, short duration funds etc. Expense ratios are also important for debt funds which invest in a limited universe of securities, e.g. Banking and PSU debt funds.

Modified Duration

Modified duration in simplest terms, is the interest rate sensitivity of a debt fund i.e. the impact of interest rate change on the scheme NAV. As mentioned earlier price increase / decrease of fixed income securities have an inverse relationship with interest rate changes. Longer the modified duration, more sensitive (both on upside and downside) is the fund to interest rate changes. Interest rates move in a cycle. Longer duration funds outperform in a falling interest rate regime whereas shorter duration funds outperform in a rising interest rate regime.

While investors may take cues from RBI’s short to medium term monetary policy to plan a duration strategy for their debt fund investments, investors should understand that different fixed income securities have different interest rates depending on the maturity terms of the securities – this is also known as the term structure of interest rates or the yield curve. RBI’s interest rate actions will impact fixed income securities across all maturities but in the interim, macro-economic factors like fiscal deficit, INR / USD exchange rate, global interest rates etc. also affect bond yields and NAVs of debt funds, especially longer duration funds.

Longer duration funds are more volatile than shorter duration funds though they have the potential to give higher returns in the long term. You should select funds according to your risk appetite. You should also select funds according to your investment tenure. Longer duration funds like medium duration funds, medium to long duration funds, long duration funds, dynamic bond funds, long term Gilt funds etc. are suitable for tenures of 3 years or more because you can overcome impacts of short term price changes over longer tenures. For short investment tenures, overnight funds, liquid funds, ultra-short duration funds, money market funds, low duration funds and short duration funds are more suitable. You can find out modified durations of debt funds in monthly factsheets or on third party research websites.

Read more about this here: Do you know how to select debt funds – Modified duration and Volatility

Yield to Maturity

Yield to maturity (YTM) of a debt mutual fund scheme is the expected return before expenses of all the securities in the scheme portfolio are held to their respective maturities, assuming no changes to the scheme portfolio. Investors should understand that yield to maturity only provides high level sense of gross returns (before expenses), if your investment tenure matches with the average maturity profile of the debt scheme matches with your investment tenure. Investors should also know that, yield to maturity is more relevant if the fund manager employs an accrual strategy, i.e. holds the securities in the scheme portfolio till maturity.

Usually, shorter duration debt funds employ accrual strategy and the portfolio YTM is one of the most important attributes of returns for these funds. Since the shape of the yield curve is upward sloping, YTM of longer duration funds is usually higher than shorter duration funds. However, as mentioned earlier these funds are more volatile; you need to have a higher risk appetite and longer investment tenures for these funds. YTM also depends on the credit quality of the underlying securities. Lower rated securities offer higher yields than higher rated securities. You should invest according to your risk appetite.

YTM is an important factor in accrual based debt funds for investments over short tenures (less than 3 years). However, you must make sure that you are comfortable with the credit risk (we will discuss credit risk in more detail in the next article). YTM can also be relevant for longer duration funds provided your investment tenure spans an entire interest rate cycle (3 years plus) but you should monitor the YTM over the period and form expectations accordingly since it can change over time if the fund manager makes active duration calls, e.g. dynamic bond funds. You can find out YTMs of debt funds in monthly factsheets or on third party research websites.

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Summary

Debt mutual funds are great investment options for investors with conservative to moderate risk appetites. They can offer higher returns than traditional bank savings products and are also more tax efficient over 3 years plus investment tenures. While bank FD interest is taxed as per the income tax slab of the investors, capital gains from debt funds held for more than 3 years are taxed at 20% after allowing for indexation benefits, which reduces the tax obligations for investors considerably. Selecting the right debt fund for your investment needs is not difficult if you understand the basic concepts involved in debt fund investments.

Suggested reading – What should be your debt mutual fund investment strategy in current economic climate

In the first part of this two part blog post, we discussed three important factors in debt fund investments viz. Expense ratio, Modified duration and Yield to Maturity and how to invest accordingly. In the next part of this post, we will discuss two more important factors involved in debt funds, credit risk and concentration risk. Please stay tuned...