Fixed income: tips for choosing the right debt UCITS

Debt mutual funds offer predictable returns and high liquidity, making them one of the preferred investment vehicles for investors with low risk appetites.

The current stock market looks volatile and the major indices are already down almost 10% from the recent high. For example, Nifty 50 is currently trading below 17,000 from its recent high of 18,600. In such a scenario, it is a good idea to park some portion of your investments in fixed income funds or debt mutual funds. Knowing and understanding these funds and the associated risks could help investors reap the benefits of this asset class and also help choose the right fund for their portfolio.

What is a Debt Mutual Fund?
A debt mutual fund is also known as a fixed income fund which invests in fixed income securities such as government securities, treasury bills, commercial papers, debentures, corporate bonds. highly rated and other money market instruments. All of these instruments have a predetermined maturity date and a fixed interest rate that the buyer can earn at maturity. They are therefore called fixed income securities. As returns are generally unaffected by market fluctuations, debt mutual funds are considered low risk investment options.

Mechanics of the mutual fund
Each debt instrument has a credit rating that indicates the possibility of default by the debt issuer in the payment of interest and principal. Typically, debt mutual fund managers use these ratings and other factors to select good quality debt instruments. But depending on the scenario, sometimes fund managers may choose low quality debt securities that offer an opportunity to generate higher returns and the fund manager takes a calculated risk.

Types of Debt Mutual Funds
Depending on the maturity period, debt funds can be classified into different types. Liquid funds are funds that invest only in money market instruments with a maximum maturity of 91 days. Dynamic bond funds invest in debt securities of varying maturities depending on the interest rate regime in effect. Contrary to the above, corporate bond funds invest at least 80% of their total assets in corporate bonds that have the highest credit ratings. These funds are suitable for investors with a lower tolerance for risk and looking to invest in high quality corporate bonds. Likewise, we have thematic funds like bank and PSU funds, golden funds and other types of funds like credit risk funds, floating funds, etc.

Consider the following
Before investing in a debt fund, assess your investment objective. For example, you may wish to park your money until the volatility of the stock market subsides or create an emergency fund, etc. So, once you have identified your investment objective, the process of selecting the right fund becomes easier.

Another factor is the holding period of the investment, as each investment objective has a specific time limit. If you have a short-term investment goal of around three months to a year, liquid funds are best. If the term is between one and three years, you can go for short term debt funds. But if you have an intermediate time horizon of three to five years, dynamic bond funds are ideal.

To conclude, debt UCITS are not risk free because they are exposed to interest rate risk, which is the effect of changes in interest rates on the value of the securities in the scheme. However, debt mutual funds generally offer predictable returns, high liquidity and thus make them one of the preferred investment vehicles for investors with a low appetite for risk.

Writing is Professor of Finance and Accounting, IIM Tiruchirappalli

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