How to select and evaluate a debt fund?

The choice of a debt fund will largely depend on your return expectations, your risk appetite and your liquidity requirement. Here are 3 things to keep in mind while choosing a debt fund for your portfolio…

· Check if your risk tolerance matches with the credit profile of the fund. If you want a zero risk fund, stick to a gilt fund as they do not carry any credit risk. If you are aggressive and can afford to take higher risk for higher returns then you can look at MIPs, credit opportunity funds etc.

· Check out your time horizon. If you require money within 1 year do not invest in a long term debt fund where instruments will typically have a maturity of more than 5 years. You can either go for a short term debt fund or more preferably go for a liquid or an Ultra Short Term fund.

· Your choice of debt fund should be based on your assessment of where interest rates are headed as it is the most critical factor determining debt fund returns. For example, if your view is that rates are headed down, then you can focus on long term debt funds or gilt funds. If your view is that rates are headed higher, then you must either stick to liquid funds or go for floating rate funds. A word of caution! Your interest rate view must be fine-tuned in consultation with your financial advisor as it is a complex subject.

Let us now look at how to evaluate debt funds?

There are a variety of very complex methodologies to evaluate a debt fund. But from a very simple perspective, you need to consider 3 key factors while evaluating a debt fund…

· A debt fund holds a mixture of bonds ranging from 1-year bonds to 10-year bonds. The best approximation is to consider the average maturity of the fund. This needs to be compared with your time horizon. If you are looking to liquidate your debt funds with 1 year or 3 years, then look for a fund with an average maturity that approximately matches your time horizon. That will reduce your liquidity risk substantially.

· Modified duration is another measure that is quite important from the point of view of evaluating a debt fund. Technically, modified duration shows the weighted average number of years it takes to recover your principal, where interest payments are also considered as part repayment of principal. Therefore, the modified duration will always be lower than the average maturity, except in case of deep discount bond where the modified duration will be equal to the maturity. What investors need to remember here is that higher the modified duration (MD), higher is the sensitivity of bond prices to movement in interest rates?

· Yield to Maturity (YTM) is a basic measure of returns on the fund. It calculates what the bond fund will earn through dividends plus capital gains. Normally, higher the YTM, the better it is for debt fund investors.

These are the most popular ways of evaluating a debt fund before adding to your portfolio.