Equity funds have always been popular among retail investors in the financial markets, but recent market corrections are a reminder that diversification is a mandatory rule when creating portfolios.
Due to negative YTM returns on stocks, investors who have used stocks in their portfolios may now consider debt as an alternative asset class as it provides a buffer during the downfall.
Debt funds, as an asset class, involve complexity in their structure, so it is very essential to consider a few points before investing in them.
We spoke to Akshat Garg, Manager-Research at Investica to decipher factors investors should consider when buying a debt fund:
• Credit quality:
In debt funds, AMC buys debt/bonds from the counterparty such as corporate, government and quasi-government, etc. By analyzing the credit rating given by rating agencies such as Crisil and Moody Analytics, we can assess whether a company can service its debt .
In the case of AAA, followed by AA, there is a good chance that the counterparty will be able to pay the principal and interest owed on time.
However, this sense of security brings lower returns, so if we reverse some steps in credit quality, expected returns will increase, but with a high degree of risk.
Investors should therefore check the average credit quality of the debt fund and see if it fits their risk appetite
• Concentration in the debt fund portfolio:
The portfolio components of a debt fund must be carefully examined. If one party receives too much of the fund’s assets, there is a concentration risk in the portfolio, resulting in a significant decrease in the fund’s NAV in the event of default.
Investors can also compare the fund’s top 10 positions in % with the category average to get a better idea of the risk related to the concentration
• Changed duration and interest rate changes:
Modified duration can help an investor understand the measurable changes in prices that will occur in response to the change in interest rates.
The concept of modified duration has been established in lieu of the fundamental principle of fixed income instruments, which is the inverse relationship between prices and returns.
Investors should consider the macroeconomic environment and the future interest rate view of the central bank before investing.
For example, in an environment where inflation has crossed the cap and there is excess liquidity in the economy, the central bank can pull the interest rate trigger through its monetary and fiscal policies.
High modified maturity debt funds will be heavily impacted as a rise in interest rates would hurt prices
• Categories of investment funds:
SEBI has introduced through its circular of 06/Oct/2017 the categorization and rationalization of investment funds for the benefit of investors.
For the debt mutual funds, 16 categories were created with different investment mandates for each of them. Since there are a variety of flavors available in the debt space that differ in their maturity, liquidity and risk, one must consider all these factors and invest appropriately.
For example, per mandate, corporate bond funds must invest at least 80 percent of their assets in top-quality bonds, while credit risk funds are debt funds that lend at least 65% of their money to lower-rated companies.
• Fund manager:
As mentioned when starting out, debt funds are complex in nature as it also requires too much due diligence when choosing securities considering numerous factors.
It is crucial that the fund manager has rich experience in the same field. As an experienced fund manager, you can read credit cycles and yield curves well and maximize risk-adjusted returns for investors
(Disclaimer: The opinions/suggestions/advice expressed here in this article are those of investment experts only. Zee Business encourages its readers to consult their investment advisers before making any financial decision.)
This post Trading Guide: 5 Key Factors to Consider When Investing in Debt Mutual Funds
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