How to choose an ideal debt mutual fund?
There are two kinds of risks associated with debt mutual funds: interest rate risk and credit risk
“Before you choose a debt fund, you need to check what kind of risk you are taking with a debt fund. You need to understand it and ask yourself if you are comfortable with that risk,” Pathak told the participants at the workshop.
He went to explain the two kinds of risks associated with debt mutual funds: interest rate risk and credit risk. “When interest rates move up, the prices of bonds fall and vice versa. Investors must also know that the longer the duration or maturity, higher is the interest rate risk,” said Pathak.
Gilt funds and long duration funds carry higher interest rate risk than the short duration or money market bond funds. This is because bonds with longer durations are extremely sensitive to changes in the interest rate regime in the economy.
“If you look at the NAV of liquid funds which cannot invest in securities of more than 91 days, you will mostly see a straight line. But once you move up to long duration or dynamic bond funds, you will notice a lot of fluctuations due to higher interest rate risk,” said Pathak.
The other risk is called credit risk. Pathak believes this risk is more dangerous as a default can cause permanent loss of capital. In the last one year, we have seen a lot of credit events in the NBFC space and many debt mutual funds were hit by defaults and downgrades.
“Credit risk funds, which invest into weaker companies with credit rating below AA, take higher risk and try to earn higher returns by better managing the credit. Default can cause permanent loss of capital,” said Pathak. “Banking and PSU funds carry lower credit risk than corporate debt funds,” he adds.
Pathak also shared another important factor to consider while choosing a debt fund. He asked the participants choose a scheme with a maturity closer or little less than their investment horizon. The strategy, he said, will help them to avoid volatility.
“If you have an investment horizon of three years, choose a fund with a lower maturity than three years, so that you do not face that volatility,” said Pathak. You can find the average maturity of a debt scheme in its monthly factsheet.
Pathak also emphasized on not to look at the past returns. He said, “Past returns can be very misleading and the performance of duration funds can specially change significantly in a small time period.”
Pathak also shared an interesting data with the participants: "last year, at the same time in September 2018, one-year return of gilt funds was close to 1 per cent and closer to 10 per cent for credit risk funds. Today, the returns are at around 14 per cent for gilt funds and 0.83 per cent for credit risk funds."