A lot has happened in the debt fund universe over the last few months. Many schemes suffered a return set back as securities they invested in defaulted on interest and principal payments when due. This meant losses for fund investors.
However, there are many debt funds that did not suffer these defaults and investors in those did not suffer losses. Ideally, one does not expect to lose money in any debt fund, however they too come with risks. If you want to ensure that yours is a high-quality fund with low risks, then here are three things that you should keep track of.
1. Fund average maturity or duration
Each security has a term or tenure through which it pays interest and at the end of which it matures by repaying the original capital invested. Average maturity (expressed in years) of a fund is nothing but the mathematical weighted average of all the maturity tenures of all securities in the fund portfolio. The longer it is, the greater is the impact of any shift in market interest rates to the funds’ daily price.
Bond prices move in the opposite direction to interest rates; if market rates fall, prices rise and vice versa. Which means funds with long average maturities will see a greater fall in price with change in interest rates as compared to a fund with a low average maturity. This sensitivity of bond price to interest rates is measured by its duration. The portfolio duration is a useful tool to measure this type of risk.
Let’s say you want to use a debt fund to keep money aside for a down payment, 3 months away. Your best bet is a liquid fund which carries a low average maturity of 1-2 months. Such a fund will be least impacted by interest rate changes. If say you need the funds only after 2-3 years, then a short-term fund with a similar average maturity will work; there could be greater price variations on a daily basis but over 2-3 year cycles the fund works to provide a stable return.
Taking credit risk or a portfolio with low credit quality enables potentially premium return, however, it does come at the risk of failure to repay. If the risk plays out, you lose money.
2. Credit quality
This is the main reason behind defaults that have happened over the last year. Information about the credit quality of securities in the fund portfolio is also available in the fund fact sheet. Taking credit risk or a portfolio with low credit quality enables potentially premium return, however, it does come at the risk of failure to repay. If the risk plays out, you lose money.
Not all funds will take this risk. If you are certain you do not want any of it, pick funds with only the best quality portfolio. This quality is reflected in the credit rating. A ‘AAA’ rated debt security has the highest degree of safety. Unfortunately, sometimes even AAA rated securities run into trouble, and these will be hard to spot beforehand. One way to be less impacted by such instances is to pick portfolios which are diversified and do not hold a very high proportion of one security.
3. Fund manager pedigree
The risk management processes of the asset management company combined with the ability of a fund manager to manage duration effectively and pick high quality securities is paramount.
While you may not be able to identify these features by simply looking at fact sheet data, you can get a sense with some basic analysis of past track record and also the number of years spent managing the portfolio. A long-term track record of performance with the same portfolio is desirable, provided the performance has been good.
It is not easy to analyse and pick debt funds as the nuances involved can get very technical. The ideal situation is to get an advisor and work together. Whatever your mode of investment, you must lean into some of this analysis before investing your money.