Equity funds have always been popular among retail investors in the financial markets, but the recent market corrections serve as a reminder that diversification is a mandatory rule in portfolio creation.

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Due to negative YTM returns in equity, investors who have leveraged equity in their portfolio may now consider debt as an alternative asset class, as it provides a cushion during the downfall.

Debt funds, as an asset class, involve complexity in their structure, so it is very essential to consider a few points prior to investing in them.

We spoke to Akshat Garg, Manager-Research at Investica to decode factors which investors should consider while buying a debt fund:

• Credit Quality:

In debt funds, AMC purchases debt papers/bonds from the counterparty like Corporates, Government and quasi-government, etc. By analysing the credit rating given by rating agencies like Crisil and Moody Analytics, we can assess whether a company can service its debt.

In the case of AAA, followed by AA, there is a strong possibility that the counterparty will be able to pay the due principal and interest on time.

However, this sense of safety entails lower returns, so as we roll down some notches in credit quality, expected returns will increase but at high risk.

Investors should therefore check the average credit quality of the debt fund and see if it suits their risk appetite

• Concentration in the debt fund portfolio:

A debt fund's portfolio constituents need to be carefully examined. If a single party receives too much of the fund's assets, it will cause a concentration risk in the portfolio, resulting in a significant drop in the fund's NAV in the case of default.

Investors can also compare the funds' top 10 holdings % with the category average to get a better idea of the risk involved with respect to the concentration

• Modified Duration & Interest rate changes:

Modified duration can help an investor to understand the measurable changes in the prices that will occur in response to the change in the interest rates.
 
The concept of modified duration is drawn in lieu of the fundamental principle of fixed income instruments i.e. the inverse relationship between the prices and yields.

Investors must consider the macro-economic environment and future interest rate stance of the central bank before investing.

For example, in an environment where inflation has bypassed the upper band and liquidity is in surplus in the economy, the central bank may pull the interest rate trigger via its monetary & fiscal policies.

Debt funds with high modified duration will be affected badly, as a rise in interest rates would hurt the prices

• Mutual fund categories:

SEBI via its circular dated 06/Oct/2017 introduced the Categorization and Rationalization of Mutual Fund Schemes for the benefit of investors.

For the debt mutual funds, 16 categories were crafted with different investment mandates for each of them. Since there are a variety of flavours available in the debt space which are differed by their maturity, liquidity, and risk, one should consider all these factors and invest suitably.

For example, by mandate corporate bond funds have to invest at least 80 per cent of their assets in bonds of top quality whereas Credit risk funds are debt funds that lend at least 65% of their money to lower-rated companies

• Fund manager:

As mentioned in starting, debt funds are complex in nature as it also involves too much due diligence while picking securities considering numerous factors.

It is critical that fund manager has rich experience in the same field. As an experienced fund manager, one can read credit cycles and yield curve well and maximize the risk-adjusted returns for the investors

(Disclaimer: The views/suggestions/advice expressed here in this article are solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)