When we talk about Equity Mutual Fund, an investor knows all the aspects and thoroughly evaluates attributes of funds and portfolio attributes but when it comes to Debt Mutual Funds, the same approach is not followed by investors who are not well versed with the different aspects of Debt Mutual Funds. So basically, Debt Mutual Funds mainly invest in a mix of debt or fixed income securities such as Treasury Bills, Government Securities, Corporate Bonds, Money Market Instruments, and other debt securities of different time horizons. Generally, debt securities have a fixed maturity date & pay a fixed rate of interest.  It is important to understand these aspects before investing in a Debt Mutual Fund.

1. Risk Element

It is popularly believed that debt mutual funds are free from risk but actually inherent three types of risk-

1) Credit Risk involves loss of capital or any other cash flow which happens due to the borrower’s inability to pay his financial obligations. Credit risk also describes the risk that a bond issuer may fail to make payment when requested or that an insurance company will be unable to pay a claim.
2) Interest Rate Risk involves the fluctuation in interest rates which affects the price of the bond. As the rate of interest increases, the price of the bond falls and when the rate of interest decreases, the price of the bond declines. Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders
3) Re-investment Risk is the risk that the proceeds from the payment of principal and interest, which have to be reinvested at a lower rate than the original investment.

2.Asset Allocation

The schemes of asset allocation are decided upon the fund manager’s view on interest rate movement and also depend upon the fund’s investment objective. Asset allocation is the rigorous implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals, and time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.

3. Rating Allocation

The credit rating of the instruments helps to deduce the credit rate of a scheme. The table has the following generalized definition of ratings and indicative level of safety.

Ratings for Long-Term Instruments Level of Safety Ratings for Short-Term Instruments Level of Safety
Sovereign Investment in G-sec. The high degree of safety A1 A very strong degree of safety
AAA Highest Safety
AA High Safety A2 A strong degree of safety
Aa Adequate Safety
BBB Moderate Safety A3 A moderate degree of safety
BB Moderate Risk
B High-Risk A4 A minimal degree of safety
C Very High Risk
D Default D Default or expected to default

4. Maturity profile/ Average maturity

The maturity profile represents the maturity of all holdings in the fund’s portfolio. Average maturity is the average maturity in days or years of all instruments held in the portfolio. Money market or short-term funds might allocate a majority of their corpus in short-term papers; hence, they will have low average maturity.

5. Modified Duration:

Bond prices are inversely related to interest rates. Thus when interest rate rises, bond prices fall and vice versa. Modified duration measures the price sensitivity to the change in interest rates. E.g., If the Modified duration of a Debt Scheme is 3 years and if the interest rate falls by 1%, the NAV of the Debt scheme is likely to go up by 3%. So if the fund manager is expecting that interest rates are likely to go down in the future, he is likely to increase the modified duration of the scheme.

6. Yield to Maturity (YTM):

It is the total return anticipated on a bond if the bond is held until maturity or is the discount rate at which the sum of all future cash flows from the bond (coupons and principal) is equal to the current price of the bond.

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