A guide to help you select debt funds

1. HOW TO CHOOSE A DEBT FUND

2. TERMS TO KNOW
• Debt funds: Mutual fund schemes that invest in
debt securities like treasury Bills, government
securities, corporate debentures, bonds and
money market instruments are called debt
funds.
• Average Maturity: A debt fund portfolio
comprises several bonds with varying maturity
dates. Average maturity is the weighted average
of maturity for all bonds in the fund portfolio.

3. • Modified Duration: The duration is the measure
of price sensitivity of the portfolio to change in
interest rates. For instance, if interest rates go down
(or up) by 1% in a month, the NAV of the fund will
go up (or down) by 4% if modified duration is four
years.
• Yield to Maturity: The Yield to Maturity (YTM) is
what the bond will earn from its coupon payments
as well as annualised gain (or loss) on purchase
price, if held till its maturity.

4. RISKS IN A DEBT FUND
• Credit Risk: Debt funds are also exposed to
the risk of default by the issuer of underlying
instrument. Checking the credit profile of the
fund is important. Returns can be enhanced by
lowering credit quality of the portfolio, which
enhances the credit risk.
• Interest rate risk: Debt funds are exposed to
risk of interest rate fluctuations, which affects
prices of underlying bonds in the fund portfolio.

5. • Liquidity Risk: Liquidity is the ease with
which a fund manager can sell a particular
security in the market. A fund faces liquidity risk
if the fund manager is not able to sell debt
securities due to lack of demand for the security.

6. Credit Risk
• The credit risk assumed by a debt portfolio can be
discerned from the summary rating profile.
• Rating profile indicates the percentage allocation
to the various rating categories.
• Government securities have no default risk.
• Higher the rating of corporate bonds, lower the
risk. Cash and equivalents have no credit risk.
• Higher the percentage of assets in lower rated
securities, greater is the default risk in the fund.

7. Fund A holds a higher percentage of AAA assets and has a better credit
quality, compared to Fund B, which holds a relatively higher
proportion in AA rated securities.

8. HOW TO CHOOSE
• Match risk tolerance with credit profile: Debt funds
invest in several instruments, from risk-free
government securities to high-risk corporate bonds.
Instruments are assigned a credit rating indicating the
credit worthiness of borrower. Higher the credit rating,
safer the investment.
• Ascertain return scenario: When interest rate rise it
makes sense to move to short term funds, while falling
rates work in longer duration debt funds. Simply put,
when interest rates are expected to decline you want to
lock the current higher interest rates by buying funds
for the long duration.

9. FUND Invests In Risk Factor Holding period Who should
invest
Gilt fund Govt. Securities Zero default risk
but high interest
rate risk
18 – 24 Month comfortable with
a high degree of
risk, for capital
appreciation
instead of
Protection, PFs
Short term funds Commercial
papers, short
term CDs &bonds
with maturity 3 -
6 months
Low, Not affected
much by changes
in interest rates
6 -12 month Investors
looking to park
surplus money,
but want to earn
higher return
than a liquid
fund.
Liquid funds Highly liquid
instruments like
treasury bills,
inter-bank call
money market,
etc
Very low Up to 3
months
Investors who
have surplus
money lying idle
and seeking
better returns
than interest
offered by banks.

10. FUND Invests IN Risk Factor Holding period Who should invest
Fixed Maturity
Plan
Instruments
with maturity
profile
matching
fund's tenure
Low-Medium 3 years or
more
Those looking to park
their money for a fixed
tenure during
uncertain
interest rate
movements.
dynamic bond
fund
Mix of bonds,
CDs, They can
invest between
zero and 100%
in any debt
asset,
depending on
the market
situation.
Medium-High.
These can shift
between
maturities
aggressively in
anticipation
of rate
changes.
6 -12 month,
duration is not
fixed
High risk takers who
want to gain from both
rising and falling
interest rate scenarios
Ultra Short
term funds
fixed-income
instruments
which are
mostly liquid
and have
short-term
maturities.
low interest
rate risk but
not immune to
market
fluctuations
3 months to 1
year
offer better returns
than most money
market instruments

11. FUND Invests in Risk Factor Holding period Who should
invest
Junk bond
funds or high
yield funds
High yield
corporate debt
of below good
quality
Medium - high 1 -3 years Those looking for
higher yield and
ready for a
higher risk
MIP 15-25 % in
equity markets &
rest in a
combination of
corporate bonds
and govt.
securities.
Medium high 1-3 years Conservative
investors seeking
regular income
can derive better
return than FDs
in a more tax-
efficient manner
using MIPs

12. OTHER FACTORS
• Expenses: Check out the expense ratio and the
exit loads. Since returns from debt funds are
typically lower when compared to those of
equity, high expenses could make a huge dent on
the returns.
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