With interest rates on a high, it’s time for you to give debt funds a serious consideration, if you haven’t already. A debt fund is a type of mutual fund that invests in both deposits and bonds.
What does an individual investor do with his surplus money? Typically, he makes a bank fixed deposit, invests in bonds or puts the money in corporate fixed deposits. A debt mutual fund makes life simpler, by investing your money in various fixed-return instruments. However, there are certain aspects that you must keep in mind while investing in a debt fund.
This is a crucial factor because a longer tenure means additional risk and higher exposure to interest rate fluctuations. The bond value is inversely proportional to the interest rates — a rise in interest rates results in a fall in the price of bonds and vice-versa. Short-duration bonds have lesser chance of being affected by significant interest rate fluctuations than long-term bonds. For example, the price of a five-year bond will fall 5% reacting to a rise in interest rate by 1%. An investor should keep in mind his risk appetite and return expectations before choosing the tenure. It’s also important to analyse the interest rate trend before investing.
The investment quality of a bond is determined by the credit rating assigned to it based on assessment of various risk factors. A high-risk bond offers higher returns, but is assigned a lower rating and, similarly, a low-risk bond offers lower returns, but is assigned a higher rating by credit rating agencies. Debt fund managers, sometimes, take higher position in bonds with lower ratings to maximise profit, but, at the time of redemption, such bonds lack liquidity. Therefore, investors should focus on funds that invest only in medium-to-high credit rating bonds and debt instruments.
Some debt funds attract investors with lucrative returns, but, on the other side, trap them by levying exit loads. Check the exit load, other associated charges and the lock-in before investing in any debt fund. A debt fund with a higher expense ratio needs higher returns to cover the expenses. Therefore, fund managers could go for lower rated bonds to fetch higher returns. Also, higher associated fund charges would reduce the actual benefits. Therefore, a debt fund with a lower expense ratio should be preferred.
Size of a debt fund
A debt fund with a large corpus means greater flexibility to diversify into various debt instruments. At the time of redemption, large funds do not need to worry about exiting investments from key government bonds having high mandatory entry ticket size, but a small fund may crash due to redemption pressure. Investors should focus on debt funds with large AUM.
It is important to analyse the past performance of debt funds with respect to various interest rates over different periods. Such an analysis would show the performance capacity of the debt fund under different scenarios; based on that, an investor can decide on the amount and duration of investment. Normally, every debt fund shows good returns when the interest rates are going down. The real test comes when the rates are rising.
Though most direct debt instruments are not traded on the exchanges, debt funds are. One crucial choice to make is between the regular dividend payout method or the growth option. Dividends disbursed under the dividend payout option are not taxable in the hands of the investor, but the fund is directly liable to tax; therefore, it is indirectly adjusted from the net asset value (NAV).
Under the growth option, the investor is directly liable to capital gains tax, i.e., 10% of the gain without indexation or 20% with indexation, whichever is less. If investors (especially those falling under 20% and 30% tax brackets) are not specifically looking for regular income, it is advisable to go for a growth option. In other words, you must analyse post-tax returns under both options before making a choice.
The writer is CEO, BankBazaar.com