How to invest in debt funds to achieve financial goals?

With over 300 debt fund schemes on offer, it may be a tough choice to choose the best scheme as per your financial goal to generate risk-adjusted returns. An incorrect debt fund choice can enhance the risk of witnessing sub-optimal returns. Thus, you as an investor must consider factoring in specific points when investing in a debt mutual fund to attain your short-term financial goals with ease. Discussed here are some important points, you must be well-versed with.

Optimum debt mutual fund category

Figure out your risk tolerance level and investment time frame of your financial goals. The circular by SEBI on the categorisation of mutual funds is a suitable way to understand debt fundcategorisation based on residual maturity, risk rating and portfolio constituents. Once you understand the apt fund category as per your risk appetite, you must review certain quantitative indicators in debt fund portfolios under the chosen fund category. These indicators are as follows –

Average maturity –

Average maturity refers to debt instruments’ weighted maturities held in a portfolio. Modified duration and higher average maturity of debt mutual funds mean higher sensitivity to interest rate changes. Thus, those funds having modified duration and higher maturity do well in a declining rate scenario while those having lower maturity and modified duration may perform well during rising interest rate scenarios.

Expense ratio –

Factor in the debt fund’s expense ratio i.e., the proportion of the scheme’s assets used for meeting its overall expenditures when selecting a fund, particularly, ultra-short, liquid, and low-duration debt fund. This is because such funds come with restricted upside potential than equity mutual funds.

Yield to maturity (YTM) –

YTM of debt mutual funds refers to the weighted average yield of portfolio constituents. Funds investing in the money market and debt securities with a higher coupon rate contain higher YTM as compared to others. Thus, the debt fund’s YTM endow a fair idea regarding the interest earnings that may be accrued in a stable rate scenario if all portfolio constituents in the fund are held until maturity dates. But note that YTM in debt fund is not the only indicator of the debt fund’s possible gains as the fund’s actual return is also based on the changes in portfolio and market valuations.

Portfolio constituents –

The debt instruments having a AAA credit rating infer the lowest credit risk while those having a credit rating of C have a higher default risk. As debt securities with reduced credit ratings hold the potential to yield higher returns, you must consider analysing the scheme’s portfolio constituents as this would allow you to assess the scheme’s upside potential. Ensure to go through the debt fund scheme’s fact sheet to take an informed decision of whether the scheme’s risk profile matches your return expectations and risk tolerance level.

Prevailing interest rate regime –

Prices of debt securities enhance during falling interest rate scenarios, given that its coupon rate tends to become higher than the newly issued securities. Reverse happens during the rising rate regime because the investor considers investing in newly issued debt securities with better coupon rates. As an outcome, debt mutual funds book higher returns during declining interest rate scenarios and vice versa.

Ending note –

Debt funds invest in the money market and debt securities like corporate bonds, government securities, treasury bills and others. Debt funds offer continuous and steady income to you as an investor. However, before you invest in debt funds to meet your short-term goals spanning up to 3 years, factor in the above-mentioned indicators to choose the best debt fund as per your risk appetite level and goal’s investment horizon.