Debt funds are a valuable addition to any investor’s portfolio and can open up numerous financial opportunities. Financial advisors often suggest investors allocate a portion toward debt funds– as they offer the opportunity to earn decent returns that can act as a source of income while still maintaining some portfolio security. But when it comes to adding debt funds to your portfolio, having the right knowledge is essential to achieving expected returns and mitigating volatility risks.

Different debt funds have different risks, returns, objectives, and time horizons, which can make selecting the right one challenging. So, here is an overview of how you can choose a debt fund that aligns with your specific needs – from understanding your financial goals and investment horizon to learning about credit ratings and fund performance.

1. Identify and understand risks

Although debt funds tend to have lower risk levels than equity funds, it’s still important to understand the risks involved and evaluate how they will affect your returns. With debt funds, there are two major risks:

• Interest rate risk – To manage this risk, evaluating the fund’s duration is important before investing. Typically, the longer the maturity period, the more exposure it has to interest rate fluctuation.

• Default or credit risk – Credit risk carries the risk of default, i.e., non-payment or a delay in payment of the interest or principal by the issuer of the funds or both. To prevent this risk, evaluate the quality of the fund portfolio and the objectives of the debt mutual fund

2. Look at the rating

It is recommended to check the credit rating of all securities held in the fund. High-rated bonds are typically given an AAA equivalent rating,indicating that they are of the highest quality and carry a nearzero risk of default. Although this may not guarantee that the fund will perform as expected; however, it does increase the likelihood that you may receive your principal amount plus interest as expected.

3. Evaluate the fund’s performance

When choosing the right debt mutual fund for investment, many investors prioritise its current return. While this is important, it should not be the only parameter you base your decision on. A debt fund’s historical track record provides a better indication of whether it can maintain its performance over time. And analysing its past performance for up to 3-4 years can provide insight into how much risk you are exposing yourself to.

4. Examine different types of funds for your goals

There are different types of debt funds – each appropriate for a different risk profile and time horizon for investment returns.

For example, overnight funds invest in securities with 1-day maturity and carry minimal interest rate risk and credit risk. Liquid funds typically invest in debt and money market securities maturing within 91 days with negligible interest rate risk. Meanwhile, ultra-short-duration funds, short-duration funds, medium-duration funds, and long-duration funds focus on funds with 3-6 months, 1-3 years, 3-4 years, and long maturity, respectively.

Comparing the benefits and features of each type is an important step to take when selecting the best debt fund for your portfolio.

Closing thoughts

Ultimately, choosing the right debt fund for your mutual fund investment portfolio is an individualised process that requires research and analysis. It’s important to consider not just the potential returns but also understand how that fund fits into your overall asset allocation strategy. Knowing what expenses you will incur, the risks involved with each type, liquidity, and whether the investment aligns with your long-term goals are all important considerations for considering debt funds.