There is a general notion that fixed income products are meant for risk-averse and retired individuals. This is not completely true. A debt portfolio when managed actively can provide much needed diversification and bring a great deal of stability to one’s portfolio. Depending on an investor’s risk appetite and risk capacity there should be a certain amount allocated to debt products in the investment portfolio.
Retail investors have a wide range of investment products which provide participation in the fixed income securities directly or indirectly. The current high interest rate scenario and the extreme volatility in the equity markets have made fixed income investments attractive.
Within this category debt mutual funds are a more active way of managing an investor’s portfolio. These funds invest in a portfolio of debt securities and adopt various active strategies to provide superior risk adjusted returns. There are various types of debt funds depending on the portfolio composition and the average maturity of the fund.
- Liquid/Ultra Short Term Funds schemes invest in the money market securities and are positioned for 0-6 months. They are a good alternative to savings accounts as they provide tax effective superior returns. Liquid funds are positioned for 0-3 months and ultra short term funds are positioned for 3-6 months.
- Short term income funds come with higher average maturity periods of 6 months or more. They are a good option as they track current yields on short term securities. These in turn depend on the policy rates and the macro economic environment.
- Medium term funds invest in debt securities having an average maturity of 15-18 months. The market rate hikes do not impact these funds greatly. They are suited for investors looking to invest for 1-2 years.
- Fixed Maturity Plans (FMPs) are debt schemes that invest in securities having an average maturity in line with the duration of the FMP. These are close ended schemes and liquidity post investment is negligible.
- Income Funds are ideal for an investor having an investment horizon of 2-3 years. During a falling interest rate scenario, investors prefer to invest in income funds to gain from mark to market appreciation.
- Monthly Income Plans are hybrid investment funds investing up to 15% in equities and the rest in debt securities. The objective is to provide regular income to the investors. However, the income in these funds is not guaranteed and is dependent on the amount of distributable income present.
Choosing a debt fund
Macro Economic factors
Interest rate cycle
The prevailing interest rates in the economy influence the returns generated by debt securities. For example, in a rising interest rate scenario, investors should choose a fund which has a lesser maturity. Thus, investors with the help of their financial advisor should choose a fund with the most appropriate tenure.
Inflationary pressures will have a bearing on the market interest rates, which will affect the debt fund returns over the tenure. Investors should be aware of this risk while investing in debt funds.
Large government borrowings put pressure on market interest rates to move up. This has an impact on the debt fund’s return.
Corporate credit growth
Higher credit growth in the corporate sector will put pressure on the market interest rates to move up. Higher corporate borrowings from the open market will also impact the return of the debt funds.
After analysing the needs and macro economic situation, investors need to short list the right debt scheme from the entire universe of debt schemes across all mutual funds. They can select the fund which is most suitable for their needs and the best scheme can be selected across the respective category by verifying the following fund characteristics.
Debt fund category
Debt funds can be categorised on the basis of the tenure, minimum investment, dividend, growth option etc. An investor should invest in a fund which has objectives matching their own.
Fund Return vs index
Before selecting a respective scheme, investors should compare the performance of the scheme against the respective index and the entire category of similar schemes of other mutual fund companies.
Portfolio risk measures
In general, risk and return go hand in hand. Higher the return always entails higher risk and investors need to analyse their own risk appetite and choose a scheme accordingly.
Portfolio average maturity
Debt funds invest the corpus in various debt instruments like government securities, corporate debt, debentures etc. The aggregate of the maturities of its underlying debt securities forms the average maturity of a fund. Investors should choose a fund having an average maturity matching their investment horizon.
Portfolio asset quality and ratings
Asset quality of the debt fund corpus is one of the most important factors to be considered while investing in a fund. One of the common mistakes investors commit is to invest in the top performing funds ignoring the asset quality and ratings of the underlying instruments. A low rated debt instrument may provide more returns, but it has more chances of default and suffers low liquidity in the debt markets. For example, a fund which invests in AAA rated instruments may give lower returns than a fund which invests in A or AA rated instruments.
Portfolio size and expense ratios
Generally, the higher the portfolio size, the lower the expense ratio and also low liquidity risk in case of heavy redemption. Expense ratio and exit loads could affect the investor’s returns over the tenure of the investment
Advantages of opting for fixed income investments
- Lower volatility than other asset classes providing stable returns
- Lower risk of capital loss in comparison to other asset classes like equities, real estate etc.
- Predictable and stable returns act as a hedge against the volatility and risk of equity investments, thus allowing an investor to create a diversified portfolio
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