How to select a good debt mutual fund ?

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Understanding how a fund generates returns will make it easy to pick one

For a long time, investing in mutual funds has been synonymous with investing in equity. Debt funds are still not in the preferred list because a debt fund is seen as a complicated product with a varying NAV and dividend compared with a simple debt product that returns the principal and pays interest. Here are six pointers that can help you understand debt funds.

First, a debt fund is a portfolio of debt instruments. This makes it completely different compared with buying a bond. A bond offers specific cash flows (interest and principal) on specific dates. The debt fund manager gets inflows from investors, buys debt securities of varying maturities, reinvests the interest and redemption cash flows he receives from time to time. He also manages the redemptions that investors make from the fund. So a debt fund is a dynamic, running manager of cash flows. All open-ended debt fund portfolios are bundles of cash flows that vary daily. This is in sharp contrast to the inert activity of buying a bond and holding it till maturity. Of all debt funds, only a fixed maturity plan (FMP) replicates this action of buying and holding. Buying a debt instrument and a debt fund are not the same.

Second, a debt fund delivers the total return. This is a combination of the return from interest earned (called accrual), and that from change in the market value of securities (called mark-to-market or MTM). A debt fund has to value its securities every day based on the current market value. This means that if it bought a bond, which paid 10% interest, and the rate in the market falls to 9%, the earlier bond will gain in value. The longer the maturity of securities in the portfolio (average maturity or duration in the factsheet), the higher the MTM of a fund. To differentiate debt funds, figure out the proportion of returns from each component.

Third, to choose a debt fund, you need to consider only one picture. How has 10 invested in the fund moved over time? Most funds publish this picture, which is the movement of NAV over time, and tells you how the total returns have changed. If you see a steady line moving up, the fund gets most of its return from accrual, and is a low-risk and low-return product. As the MTM component in its total return increases, the volatility in NAV will rise. Remember that over time, the NAV graph will only move up. This is because a debt fund will have a steady interest income, which will make good the MTM losses over time. Your choice of fund should depend on how long you can stay and how much movement in NAV you are prepared to take.

Fourth, the return from a debt fund will vary based on the total return it generates, but within a category, there'll be little difference. If you see a steady month-on-month, quarter-on-quarter return, you should be fine. Expect the intermittent drop in performance to correct with time. It is a reasonable assumption that most debt funds will choose carefully, not take too much risk, and manage to stabilise the NAV over time. Default is a highly sensationalised event in investors' minds, but the truth is that no fund manager will hold debt that has dropped in credit rating, let alone wait until default. The risk of selecting a wrong debt fund is much lesser. What you need to worry about are outliers. If most funds are delivering 9%, a fund returning 10% should raise your eyebrow, while a fund giving 8% has no case. If you choose the average debt fund, you will do just fine.

Fifth, debt markets involve a good amount of math, logic and analytics. Investing in debt requires taking a view on interest rates, which the fund manager will do. If the expectation is for the RBI to reduce interest rates, the funds have positioned themselves to make some MTM gains should the event occur. But it is also true that interest rates in the market are very high, making accruals attractive. If your intent is strategic, you will be fine investing in income funds that offer both. If your intent is tactical, you will choose a long-term debt fund when the market panics, and sell when the rates begin to fall. If you like the best of both, you may pick shortterm debt funds that straddle both the worlds. Make your choice based on your understanding of debt markets. Do not dabble in speculation if ideas like the yield curve and interest rate expectations are too technical for you.

Sixth, expenses directly impact the return. If a fund earns 10% as interest income and pays 2% as expense, 20% of its direct income is gone. Debt funds cannot and do not charge expenses like equity funds. If the expectation is for rates to fall, which in debt markets is a bull run as prices of bonds rise, distributors will ask for more commissions to sell debt funds. In the past six months, expense ratios of several aggressively selling debt funds have risen. Between two debt funds with similar average maturity, NAV volatility, and return, choose the one with a lower expense ratio.

 

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