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How To Select The Low-Risk High-Yield Debt Funds

In my previous blog post 'How To Find The Best Mutual Funds With Least Risk', I had explained how to choose the least-risk equity mutual funds.

Since equity investment is different from debt investment, the risk characteristics of debt mutual funds are different.

This blog post takes a close look at such features, and how you can use them to earn great returns from your debt mutual funds... with minimum risk.

Credit Quality

One of the key risks of investing in any fixed-income debt product is the risk of default.

There have been numerous instances where the companies or banks have not only
(a) not paid the interest to its investors / depositors, but also 
(b) failed to return the principal amount.

Therefore, the quality of the borrower assumes great importance.

The role of the fund managers, managing the debt funds, is to ensure that such an eventuality does not happen. Their outlook, therefore, is to invest your money primarily in the top-rated companies. However, to improve the returns they may sometimes take a calculated risk and invest a part of the corpus in medium-rated companies / banks also.

Accordingly, just like we have the AAA, AA, A+, A etc. rated companies, the debt mutual funds too have a similar Credit Quality rating. This is worked out on the basis of where all the total corpus has been invested.

Your role is to choose the funds that match your risk profile. If you are totally risk averse, you can stick to the Gilt Funds (which have zero risk of default as the corpus is entirely invested in the Govt. Securities) or debt funds with AAA Credit Quality rating. Those willing to earn higher returns, can consider the AA or A rated debt funds (of course, with a limited corpus and not your entire capital).

Warning! Don't go below A rated debt funds.

Average Maturity

All fixed-income instruments, such as bonds, debentures or deposits, have a defined maturity period. This is when the company or the bank would return the principal amount.

In a single deposit or bond, the maturity date and hence the time remaining till redemption is pretty straighforward.

But what about debt mutual funds that invest in many companies / banks?

Again, simple! They just have to calculate the weighted average of their portfolio, to arrive at the Average Maturity.

Suppose a debt mutual fund has bonds worth Rs.1 lakh maturing after 1 year, Rs.2 lakhs after 2 years and Rs.3 lakhs after 3 years. Then, the Average Maturity of the fund works out to 2.33 years.

But, since most debt funds are open-ended funds — where you can redeem and invest whenever you want — why is the Average Maturity important?

least-risk-debt-mutual-funds
Invest only in the adequately secured and protected debt mutual funds.

Average Maturity is important because of the concept called "interest-rate risk".

I had recently covered this aspect, while explaining how You Can Lose Money Even In The Govt. Securities.

Summarizing the same:
one. Bond prices (and hence the NAVs of debt funds) change with interest rate movement

two. This change is inversely related i.e. as interest rates rise, the NAVs fall (hence you lose money) and if rates fall, NAVs rise (hence you make money)

three. Longer tenure bonds (or funds with higher Average Maturity) are affected more than the shorter tenure bonds (or funds with lower Average Maturity).

Accordingly, you must invest in long-term debt funds when the interest rates are in a declining trend. However, in a rising rate scenario, it is best to stick to ultra short-term funds (as the impact of interest rate movement on such funds is marginal).

Since this aspect is of critical importance, read more about it in my blog post Simple and Smart Strategy to Buy the Best Debt Funds.

Yield to Maturity (YTM)

This number gives you the average returns that you can expect from the particular debt fund.

The Coupon Rate of a bond or deposit is important, only when you buy it at the face value. But, as we have seen earlier, when you buy from the secondary market, the price is different from the face value. So, YTM becomes more relevant than the Coupon Rate.

Relax:

As I had once explained, there is nothing cryptic about YTM. It is a very simple concept. So please don't get hassled by the jargon. Just spend a few minutes and it will all be crystal clear to you.

When you have to choose between two funds  both having similar Credit Quality and Average Maturity  the one with higher YTM becomes your first choice (naturally!).


This, in a nutshell, is how to identify the least-risk debt mutual funds with maximum yields.

Warning: As I had repeatedly cautioned in my post on low-risk equity mutual funds also, you have to apply these numbers in the right context.

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