Debt funds are the ideal option for businesses for fund parking due to their low risk, liquidity, and stable capital appreciation. Choosing the right debt fund for your business can feel overwhelming, given the numerous metrics available for evaluation.

However, by focusing on these five key factors, you can simplify the process of choosing the right debt fund for your business.

In today’s KOFFi break, we’ll discuss what are those 5 key things you as a business look into a debt fund before making any discussion. 

Introduction to Debt Funds

Debt funds are the type of mutual fund scheme that only invests in fixed-income securities like bonds, treasury bills, commercial papers, and money market instruments. 

Debt funds offer relatively stable returns, with high liquidity, and a low-cost structure compared to other fund parking options.

These funds are considered lower risk compared to equity funds, as their major assets are allocated into high-quality fixed-income instruments.

Debt fund’s major assets are allocated into government securities, corporate debt, and bonds. Fixed interest earned on these securities is usually added as dividends at the end of the day, which is mainly responsible for how a debt fund’s NAV(net asset value).

So looking into the funds portfolio you’ll get an idea of future returns, risk, and liquidity.

Along with that, here are a few things that you should watch before choosing a debt fund:

1. Average Maturity
2. Modified Duration
3. Liquidity
4. Asset Under Management
5. Credit Risk 

Let’s dive in!

[1] Average Maturity

Average Maturity is a key metric in debt funds that showcases the average maturity of all the securities in a funds portfolio. 

As debt funds invest in various debt securities, all of them have a Maturity. That’s why average maturity is important because it gives you an idea of the fund returns stability and sensitivity to the interest rate change.

In simple terms, funds with higher average maturities tend to be more volatile in the short term since their major objective is to deliver higher returns over a long period.

So, before going with any debt fund, matching your investment horizon with their average maturity is always a good idea.

How to interpret Average Maturity: 

1] Low Average Maturity 

A fund with a lower average maturity shows that the goal of the fund is to provide higher returns in the short term.

So if you are looking for a debt fund looking for a short-term fund parking, a fund with a lower average maturity will be perfect for you.

Here are a few funds that generally have low average  maturity 

• Overnight funds.
• Ultra short-term funds.
• Short-term funds.  

2] Higher Average Maturity

A fund with a higher average maturity shows that the goal of the fund is to provide higher returns in the long period.

So if you are looking for a debt fund for the long term, a fund with a higher average maturity would be the perfect option.

Here are a few funds that generally have higher average maturity. 

• 1. Gilt funds
• 2. Long-duration funds.

[2] Modified Duration 

Modified duration is a key metric that helps investors understand how the price of a debt security like a bond will change interest rate by one percent. 

The modified duration is like a sensitivity meter for bonds and debt funds. 

As interest rate movement impacts the overall performance of debt funds, it’s important to determine modified duration while selecting debt funds

How to interpret the modified duration

• Higher Modified Duration: This indicates a higher sensitivity to interest rate change. This means funds have potential higher risk and higher returns if the rate decreases, but more significant losses if the rate increases. 
• Lower Modified Duration: This indicates a lower sensitivity to interest rate changes. 

This means funds have lower risk and more stability, but potentially lower returns if rates decrease

[3] Liquidity 

Before choosing a debt fund make sure it should be liquid enough. Funds that have a higher percentage of corporate bonds, and government bonds tend to be less liquid in the short term since these securities have longer Maturity. 

If any redemption pressure comes on the fund, it will force the fund manager to sell their holding at a discounted price which brings the NAV (Net Asset Value) down, lowering the returns.

Here are a few things that you can look into to determine a debt fund’s liquidity:

• Cash holding: Looking into the percentage of fund assets held in cash or cash equivalents will help you to determine fund liquidity.  A fund with a balanced portfolio of securities and cash holding will provide better liquidity and can’t be forced to sell at a discount under redemption pressure. 
• Redemption terms: Every debt fund has its redemption policy which states exit loads and lock-in periods. Funds with lower exit load and no-lockin period are generally more liquid. 
• Average maturity: The average maturity of the fund’s holdings can impact liquidity. Lowering the average maturity indicates funds are more liquid. 

[4] Asset Under Management

The debt funds don’t share details about any investor holding a large chunk of the units. This means you can’t tell if there’s a major investor with most of the units.

So, as an investor, it’s best to steer clear of such debt funds with small amounts of assets under management.

If any such investors decide to redeem their holding, the fund manager will forced to sell the fund holding at discounted prices, which lowers the fund NAV (net asset value).

It is a good practice to find a fund that has better AUM.

[5] Credit Rating

Credit rating indicates the creditworthiness of the securities held by the debt funds.

Even though debt funds are low-risk instruments they still come with a credit risk. They deal with debt instruments that have the risk of default. Determining credit rating is important to the risk assessment of the debt funds. 

A fund with higher credit ratings (e.g. AAA suggests a lower risk of default, while a lower rating (e.g. BB or below) indicates higher risk.

As a business owner, you should always opt for high-credit-rating debt funds to secure the safety of your business funds. 

Other than all these metrics you can look into SEBI riskometer. 

The Security and Exchange Board of India (SEBI) riskometer is a visual tool that helps you understand the risk level of the debt fund scheme. 

Final Thoughts

Selecting a debt fund for your business fund parking is a crucial yet confusing task, especially in markets like India, where you can find thousands of debt funds. Checking these five metrics before making a decision will help you select the right debt fund for your business fund parking.

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