A debt fund can bring much value to your overall portfolio, if chosen properly. ET Wealth helps you decode the basics.
TERMS TO KNOW
Average Maturity: A debt fund portfolio comprises several bonds with varying maturity dates. Average maturity is the weighted average of maturity for all bonds in the fund portfolio.
Modified Duration: The duration is the measure of price sensitivity of the portfolio to change in interest rates. For instance, if interest rates go down (or up) by 1% in a month, the NAV of the fund will go up (or down) by 4% if modified duration is four years.
Yield to Maturity: The Yield to Maturity (YTM) is what the bond will earn from its coupon payments as well as annualized gain (or loss) on purchase price, if held till its maturity.
CHOOSING RIGHT
Match time horizon with maturity profile: Ascertain the time period for which you wish to stay invested and identify a fund with a matching maturity profile
Match risk tolerance with credit profile: Debt funds invest in several instruments, from risk-free government securities to high-risk corporate bonds. Instruments are assigned a credit rating indicating the credit worthiness of borrower. Higher the credit rating, safer the investments
Ascertain interest rate scenario: When interest rates rise, it makes sense to move to short term debt funds, while falling rates work in favor of longer duration debt funds.
RISKS INVOLVED
Interest Rate Risk: Debt funds are exposed to risk of interest rate fluctuations, which affect prices of underlying bonds in the fund portfolio.
Credit Risk: Debt funds are also exposed to the risk of default by the issuer of underlying instrument. Checking the credit profile of the fund is important. Returns can be enhanced by lowering credit quality of the portfolio, which enhances the credit risk.
Liquidity Risk: Liquidity is the ease with which a fund manager can sell a particular security in the market. A fund faces liquidity risk if the fund manager is not able to do so due to lack of demand for the security.
Author: Hemant Dharnidharka
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