Debt mutual funds offer returns in the form of interest payments on investments. They are less volatile than equity funds and can be an effective way to diversify your portfolio, based on your risk appetite and investment goals. However, picking the right debt fund requires extensive research to ensure your financial needs and goals are aligned with your risk level and investment tenure.
While fixed deposits and Public Provident Fund (PPF) come with a definite lock-in period, debt funds allow you greater liquidity. This is because they invest in debt instruments with varying maturity periods. For example, liquid funds have a maturity in days while income funds have an average maturity of multiple years. It is best to choose a debt fund with an investment horizon that matches yours, so you can liquidate the investment as and when required.
When choosing a debt mutual fund, you should look at the expense ratio and average duration of maturity. This will help you decide whether the fund is worth investing in or not. Higher expenses and longer maturities will reduce your net returns. In addition, you should check the credit quality of the debt instruments in which a fund is invested. Bonds are rated by credit agencies according to their ability to yield returns. The higher the rating, the safer your investment will be.
Another key factor to consider is the fund manager’s investment strategy and the interest rate regime in the economy. A falling interest rate regime may encourage the fund manager to invest in long-term bonds while a rising rate will push him to opt for short-term securities. The best tool to assess a bond’s sensitivity to interest rates is its modified duration, which represents how much the price of the security would change if interest rates go up by 1 per cent.
Lastly, when choosing a debt fund, you should consider how tax efficient it is. Capital gains realised on the sale of units are added to your overall income and taxed according to your slab rate. Gains realised on the sale of units that have been held for more than three years are taxed at 20% after indexation.
To make the most of your investments, you should choose a debt fund with high credit ratings and a low expense ratio. It is also a good idea to diversify your portfolio by investing in multiple debt funds with different maturity periods. This will help you earn better returns by minimizing the effect of interest rate fluctuations on your portfolio. In addition, you should track your investment performance and monitor the prevailing interest rates regularly to stay updated on changes in market trends. By doing so, you will be able to maximise the benefits of your debt funds and reach your financial goals.