Your discussion with your wife reminds you to start saving for the down-payment of a home loan that’s coming up in a few years. You are looking for something more innovative, flexible and tax-friendly. Someone in your office told you about starting a SIP in debt mutual funds. You looked up on the internet and found so many options that confused the hell out of you.

Worry not. In this article, we’ll explain to you the main risks in debt funds and a step-by-step manner and some killer tips on how you can find the right debt fund for your financial goals.

Decoding the risks in debt fundsRemember: Unlike fixed deposits and post office schemes, debt funds are not entirely risk-free. However, you can quickly reduce the risks to a very manageable level with some basic knowledge and planning. Risks in debt funds are mainly of two types as follows:

  • Interest rate risk: The debt fund internally invests its money in various fixed-income investments. These investments are of different durations. For example, the fund may invest in a commercial paper maturing in the next 30 days. It may also invest in government security maturing in the next 15 years. The market price of the security depends on the rate of interest declared periodically by RBI, the country’s central bank. When the rate of interest increases, the price of bonds falls and vice versa. So, the fund’s return will fluctuate depending on the duration of investments.
  • Credit risk: A debt fund invests in many fixed income securities like commercial papers, bonds, treasury bills etc. Each security has some possibility of default in repayment of the money invested in that security. That is known as credit risk. Credit risk is a more dangerous risk as it can cause a permanent impact on the NAV of the fund.

3 Step Process for selecting the right debt fundNow that we are clear on the risks involved, let us look at a simple three-step process for selecting the right fund:

Step# 1: Decide on your risk appetite and shortlist the fund categories:Debt funds are an essential fixed income component of your portfolio. Since fixed-income investments form the foundation of your investment portfolio, you may not want to be too adventurous in this space. If you prefer funds with very low credit and interest rate risk, an excellent choice is to go for liquid funds. They invest in papers having a maturity of fewer than 91 days. You can also choose gilt funds if your time horizon is very high and you don’t want to take any credit risk.

Step# 2: Shortlist the funds in the chosen category:Once you are clear on the category of funds, you can look up the various schemes available in the market. While choosing the schemes, you can prefer funds from established fund houses with a reasonably high Assets Under Management (AUM). Take care that you don’t blindly choose schemes basis past returns.

Step# 3: Check the portfolio of the fund:Now you have a shortlist, and it’s not the end of it. Now, for the schemes that you’ve selected, you need to download the fund factsheet (available on the fund’s website) and check the portfolio of the scheme on the following parameters:

  • Average maturity – will help you get an idea of the interest rate risk in the scheme
  • Portfolio classification by credit rating – will tell you about the credit risk in the scheme.
  • The expense ratio of the scheme – It is an essential factor in debt schemes. The lower, the better.
  • Exit load – This is a penalty for exiting the scheme before a certain number of days/months after investing. Nil or a very low expense ratio is the best.
  • Diversification – The more the number of securities, the better, as it helps reduce the credit risk for the portfolio as a whole.

Some additional tips for investing in debt funds:

  • Don’t choose schemes based on past returns. Instead, look at your own financial goals, the risk involved in the scheme and its portfolio composition.
  • If the investment amount is substantial, try to spread it into 2-3 schemes to reduce the fund manager risk.
  • You should be prepared to hold the investment for a minimum of 3 years if you are looking for tax efficiency. This will make it classified as “long-term capital gain” for tax purposes. So, spend ample time researching the scheme before investing.
  • Invest in direct plans of the schemes as they come with a lesser expense ratio. The resulting cost saving can make a significant impact on your long-term returns.
  • It is ok to invest in one fund for multiple financial goals. You can invest in multiple folios of the same fund to tag the investment better in your financial plan.
  • It is important to periodically monitor the portfolio of the debt fund on risk parameter. That’s why you should not invest in too many schemes as it will not allow proper monitoring later.

ConclusionDebt mutual funds are a low cost and innovative investment option for young investors looking beyond the regular fixed deposits and post office schemes. You can also do some wise tax planning to significantly reduce the tax impact of the income from debt funds. However, debt fund selection is trickier than equity funds, and you need to first be clear on the risks involved. Selecting the right fund for your needs and monitoring the risk can help you achieve your financial goals in a hassle-free way.