Having debt instruments in your portfolio to help diversify and hedge the risk against the volatility of the stock market is essential. And debt mutual funds are a great way to go about that. While debt funds are safer and more straightforward to invest in as compared to equity funds, there are some common mistakes investors make while investing in them. Here’s a quick list so that you can avoid those mistakes.
- Not looking at the debt fund holdings’ credit quality
All debt instruments that a debt fund invests in such as corporate bonds, government securities, treasury bills, certificates of deposit, etc., come with a credit rating. These credit ratings are provided by credit rating agencies such as CRISIL. The credit rating of debt security tells you about the issuer’s creditworthiness – the ability to repay the principal amount and the interest. All debt instruments come with credit risk and hence it’s essential to check the credit quality of the instruments that the debt fund you want to invest in holds.
- Only looking at the returns
It’s important to note that debt securities with lower ratings tend to have higher interest rates to compensate for the higher credit risk. Hence, some debt funds may take on higher credit risk to earn higher returns. AAA is the highest credit rating and the second-best is the AA rating. This is followed by A, BBB, BB, B, C, and D. The lower the rating of a debt instrument, the higher is the credit or the default risk. Thus, you need to ensure to go beyond just the returns and check the underlying debt securities and their credit quality before you invest in debt mutual funds.
- Ignoring the interest rate risk
While debt funds carry lower risk than equity funds, they are not completely risk-free. A major risk of debt funds, or any debt instrument, is the interest rate risk. When the level of interest rates changes in the economy, it directly impacts the prices of debt instruments such as bonds. Bond prices have an inverse relationship with interest rates – when the interest rates rise, the bond value falls. So, debt funds that heavily invest in bonds benefit when interest rates drop in the economy as the value of their underlying securities – bonds – goes up and this is reflected in the Net Asset Value (NAV) of the debt fund. The opposite happens when interest rates rise.
- Not considering your investment horizon
As per the categorization of the Securities and Exchange Board of India (SEBI), there are as many as 16 types of debt funds in the country. Most of them are categorized based on their investment horizon and the risk they carry. Hence, it’s crucial that you think of what your investment goals are and what their ideal investment horizon is before you invest in debt mutual funds. For instance, if you have a short-term goal that you need to meet within a year, then you should look at debt funds like ultra-short duration funds.
These are some of the most common mistakes that you should avoid while investing in debt funds. You should also make sure to understand the debt fund’s objective, look into the fund manager and their experience, and understand whether adding a specific debt fund would help your current investment portfolio. Many investors also make the mistake of investing in too many debt funds without realizing what their ideal asset allocation proportion between equity and debt should be as per their risk tolerance and financial goals. Hence, make sure to have a clear idea about your investment strategy before you invest in debt mutual funds.