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How to select a debt fund

Numerous factors affect the returns of debt funds. But should they be of concern to you?

Where will interest rates be over the next three years?
Will rates rise over the next year?
Depending on where interest rates are headed, where should I invest?

There are some questions that are very difficult to answer. And the ones mentioned above fall bang into that category. Yet, we cannot ignore them because an overwhelming number of reader queries to Value Research have taken on this tilt. Now we certainly understand why readers would want an answer. If you knew interest rates are going to inch upwards, you would put your money in short-term debt funds. Conversely, if they were going to head south, you would lock your money in long-term debt funds. Hence the question: where are interest rates headed?

There are way too many variables that go into determining the direction of interest rates -domestic and international. It is difficult for an experienced debt fund manager to make such a call, so one cannot expect a retail investor to even venture into that zone. If the days of easy predictability of bond prices and interest rates are over, how should an investor decide where to invest? Purely on the basis of his time frame and his preference for risk. Don't even try to guess where interest rates are headed, just look solely at your requirements and leave the rest to the fund manager's skill. “Too much has been communicated to the investor on the interest-rate cycle. Investors must look at debt funds solely on the basis of their investment horizon and accordingly narrow down on the right scheme,” says one debt fund manager.

Pointers to keep in mind when selecting a debt fund
Duration: First see if the fund manager's mandate is what suits you. You cannot have an investment horizon of 45 days and invest in a long-term debt fund.
Returns: Is the fund generating higher returns than its peers? Check the portfolio. It could well be that the fund manager is compromising on quality of paper to generate those extra returns.
Size: In the debt market, on an average, the minimum lot size is around Rs 5 crore while the minimum ticket size in a primary issue could be Rs 50 crore. Hence a very small fund is at a distinct disadvantage. On the other hand, a large-sized fund may be in a position to strike better deals but if faced with huge redemptions, the market might not have adequate depth to bail it out. Avoid the two extremes.
Costs: Expenses have a significant impact on the relative performance of debt funds. It's important to see that your debt fund does not have the highest expense ratio while delivering just about average or below-average returns. The spread of returns, especially in big short-term fund categories, is very narrow. A small difference in return can significantly change the ranking. For example, among liquid funds, 1-year returns of around 59 of the 112 funds is stacked in a range of 0.50 per cent.

Information regarding the portfolios of funds and expense ratios is available on our website www.valueresearchonline.com.