Fixed deposit (FC) rates registered a steady dip ever since the MPC started rate-easing cycle at its February meet. The latest 50 bps cut in repo rate and easing liquidity conditions should lead banks to cut FD rates more. This may push fixed income investors towards debt mutual funds to benefit from easing rate cycles. However, with over 300 debt funds and 16 categories, wrong fund choice may lead to sub-optimal returns/capital loss. Here are some key factors to help make informed decisions on debt funds.
Current cycle
Interest rate cycles play a major role in the price movement of bonds and other fixed income securities. Prices of securities such as bonds have an inverse relationship with direction and quantum of interest rate changes. Their prices rise during falling rate regime as coupon rates would be higher than those of similarly rated but freshly-issued debt securities. Conversely, rising interest rate regimes lead the prices of existing debt securities to fall as investors would prefer investing in newly-issued securities offering higher coupon rates. Thus, debt mutual funds (MFs) generate higher returns during falling interest rate regime and vice versa.
The next step involves selecting the right debt fund category, factoring in risk appetite and the time horizon of financial goals. SEBI’s circular on MF categorisation can help investors in selecting right fund category.
For example, the latest change in the monetary policy stance to neutral reduced the prospect of further rate hikes in the immediate future. Thus, investors must prefer funds pursuing accrual-oriented strategy like money market funds, ultra-short, low- and short-duration funds, etc. Investors can also opt for dynamic bond funds as these carry flexibility to change investment strategy as per changes in the interest rate cycle. Once identified, check the following metrics to choose the right fund.
Maturity, duration
Average maturity of a MF is the weighted average of maturities of various fixed income instruments held in its portfolio. Modified duration is the sensitivity of its portfolio to interest rate fluctuations. So, if the modified duration of a debt fund is 5%, then NAV of the fund should rise by 5% for every 1% reduction in interest rate. Thus, debt funds with higher average maturity and modified duration are more sensitive to interest rate changes. This leads debt funds with higher average maturity and higher modified duration to perform well during easing rate cycles.
Expense ratio
Expense ratio of a MF is percentage of total assets used to cover operating expenses. This is important when selecting debt funds, especially in liquid, ultra-short and low duration categories, as these have limited upside potential compared with equity, credit risk and debt funds of longer duration. Thus, pick direct plans of debt funds as they have lower expense ratios than regular plans.
Yield to Maturity (YTM)
Debt fund fact sheets, published monthly, show portfolio constituents’ credit ratings and creditworthiness of the fixed income issuers. Reviewing these would provide a fair idea about the credit risk exposure of debt funds.
YTM of a MF indicates the weighted average yield of portfolio components in terms of percentage. This is a rough estimate of potential interest income a debt fund can deliver if its portfolio holdings are held till maturity. A higher YTM can also indicate greater credit risk profile of fund as fixed income instruments with lower credit ratings usually offer higher yields. Also, YTM of a MF shown at the time of investment may not match actual returns due to factors like subsequent portfolio churnings. While comparing debt funds, always consider net YTM, i.e. gross YTM minus expense ratio.
(The writer is CEO of Paisabazaar)
Published – June 23, 2025 06:32 am IST
