The debt component of any portfolio must be carefully constructed. Fixed deposits and bonds are the most common securities in a debt portfolio. Fixed deposits have recently had low-interest rates and make up a smaller portion of most portfolios. Regardless, there are a variety of debt mutual funds available to investors, depending on their time horizon and financial objectives. The wide variety of these mutual funds presents a challenge to the investor in terms of selecting the best option from the available options. A debt mutual fund is a type of fixed-income fund that invests in bonds, debentures, commercial papers, and other debt securities. As an investor, the basic rule is to choose debt mutual funds that correspond to the time horizon of the financial goal. Aside from this basic rule, there are a few other things to keep an eye out for.
Average Portfolio Maturity
This tip is especially important for short and medium-term goals. Each debt security has its own duration (duration). The average portfolio maturity of that fund is the weighted average tenure of all debt securities in the portfolio. If a debt fund’s average portfolio maturity is 7 years, it means that the debt securities in that portfolio mature after 7 years on average. It is worth noting that the higher the average portfolio maturity, the riskier the fund. As a result, it is prudent to choose debt funds with average portfolio maturities that are lower than the time horizon of the set financial goal. Assuming you have a four-year goal, you should select a fund with an average portfolio maturity of 1-2 years. The question then becomes, “Why not select a fund with an average portfolio maturity equal to the tenure of the set financial goal?” When you do this, even if the average portfolio maturity matches the tenure of your financial goals, there may be individual securities in the portfolio that are older than the fund’s average tenure, making the fund riskier.
Credit Rating
A credit rating is a ranking assigned by a credit rating organization to debt security. These ratings are endorsements of the health of a specific debt security as well as the ability of the entity issuing the security to make timely interest payments. When evaluating the credit rating of a specific debt mutual fund, it is critical to consider the credit rating assigned to each major debt security held within the fund. A high credit rating indicates a low level of credit risk (this is the risk of not receiving timely interest payments and principal repayments).
It is always wise to invest in debt funds where the majority of the debt securities in the fund have a high rating. It is also worth noting that the returns from debt funds with high credit ratings would be moderated. Furthermore, if you do not want to take on any credit risk, you can stick to safer types of debt funds, such as money market funds, which primarily hold short-term cash equivalents. Long-term bond funds, which invest in long-term government bonds, are popular with investors because the payments on these bonds are guaranteed by the government. These bonds’ interest payments and principal repayments are deemed guaranteed. As a result, the credit risk associated with these funds would be negligible. This is not to say that these bonds are without risk.
As a substitute for fixed deposits, investors may attempt to use conservative hybrid funds that invest primarily in bonds and cash equivalents with a small portion in high-quality dividend stocks. However, such an approach is flawed because a market-linked fixed-income product can never provide the same level of certainty and stability as a traditional fixed-income instrument. As a result, those seeking absolute security from their investments should stick to fixed and recurring deposits.
Before investing in debt mutual funds, we must consider much more than just the duration of our financial goals. Before making any decisions, we must first understand the types of debt funds in which we wish to invest. We must be willing to forego the absolute safety provided by traditional fixed-income instruments in exchange for the reasonable safety and improved tax efficiency provided by debt mutual funds. Only then will we be able to enjoy a satisfying investment journey with debt mutual funds.
