Investing in the current financial scenario can be daunting and confusing for a beginner. While FDs and RDs are traditional and safe investment instruments, they offer low returns. That’s why, investors have shifted their preference to alternative investments like debt funds that combine this low-risk aspect with better returns. The returns on debt funds depend on their investment tenure, but most funds average a return of 7%-9% p.a. However, debt funds also carry certain investment risks like credit and interest rate risk. In this article, we highlight the tips to follow when investing in debt funds. We also explore the traps to avoid when investing in debt funds to minimise the risk exposure of these funds and still relish better returns than traditional instruments like FDs.

Here’s a list of tips you can use when investing in debt funds:

Determine your investment goal

You cannot start investing in mutual funds without first carefully evaluating your purpose for investing. Setting concrete and definite goals for your debt fund investments helps you estimate your target amount and choose the right fund.

Review the credit rating of the securities

A prudent tip to follow when investing in debt funds is to check the credit rating of the fund’s underlying securities. The credit rating of the underlying instruments signify the creditworthiness of the issuer and their ability to repay the debt. Choose debt funds that invest in high-rated securities to minimise exposure to credit risk.

Check the expense ratio

The expense ratio of the fund is the annual fee the AMC charges to cover operational and administrative costs of managing the fund. Look for debt funds with low expense ratios to preserve more of your returns.

Choose the right fund category

Before you pick a debt fund for investing, try gaining thorough knowledge about the types of debt funds and how they operate. Debt funds are generally classified on the basis of the maturity profile of the underlying securities. Choose funds based on your investment horizon and risk appetite. For instance, if you have short-term goals, invest in ultra-short or liquid funds. Implement this pro tip when investing in debt funds to optimise your investment.

Diversify your portfolio

While debt mutual funds are low-risk investments, they are not completely risk-free. Therefore, you need to implement diversification to minimise portfolio risks. Consider investing in debt funds that hold securities from different sectors and issuers. If you’re investing in multiple debt funds, opt for funds with varying maturities and ladder your investment.

Monitor your investment

Track the fund’s performance, review your investment periodically, and revise your portfolio if needed. Remember that changing market conditions, interest rates, and other macro factors can impact your investment, requiring a reshuffle. This is a valid tio to follow when investing in debt funds as well as other mutual fund schemes.

Consider your time horizon

As mentioned earlier, review your time horizon carefully when investing in debt funds. Different types of debt funds are suited for different investment horizons. Liquid funds are ideal for time horizons of up to 3 months, while ultra-short funds are better-suited for investment horizons of up to a year. Long-term debt funds are best for investment horizons of 1-3 years.

• Set clear investment goals, outline your time horizon, and diversify your portfolio when investing in debt funds.
• Remember to check the credit rating of the underlying asset and the expense ratio of the fund.
• Monitor your investment periodically and reshuffle your portfolio if required.

Now that you know all the tips to follow when investing in debt funds, here’s a list of traps you must avoid while making your investment:

Assuming debt funds are risk-free

Many investors park their money in debt funds assuming these funds are completely devoid of market risk. While debt funds are less risky than equity mutual funds, they are not entirely risk-free. Understand the risks involved in debt fund investing before choosing a fund for your MF portfolio.

Not diversifying your portfolio

Concentrating your investment in a single debt  mutual fund scheme can increase your risk exposure and compromise returns. Instead, you consider investing in different debt fund schemes and categories to diversify your debt holdings.

Failing to recognise credit risk factors

One of the most significant risks in debt funds is credit risk. It is the risk that the issuer of the debt security will default on the payment. To avoid this trap while investing in debt funds, you need to carefully evaluate the credit rating of the underlying securities. Try not to be tempted by the high returns allure of high-yield funds that invest in non-investment-grade bonds, exposing your investment to a higher default risk.

Not considering the interest rate risk

As an investor, you must remember that debt funds are sensitive to interest rate changes in the economy. An increase in interest rates can lower the fund’s value because the underlying bonds get devalued.

Ignoring the expense ratio

Expense ratio of a debt fund varies from one mutual fund scheme to the next. Ignoring the expense ratio can pile up your investment costs and eat away at your earnings.

When done right, investing in debt funds can help investors diversify their holdings and consolidate their portfolio with an element of stable returns. Researching and comparing mutual funds beforehand helps investors find ones that best match their investment goals and time horizon. However, investors should be careful about certain traps of investing in debt funds like credit risk, interest rate risk, and high expenses ratios.

Want to expand your portfolio with debt fund investments? Start investing in mutual funds on the Bajaj Finserv Mutual Fund Platform. This smart platform lets you start lump-sum and SIP investments with just a few easy clicks. It also offers a plethora of data on funds and their historical performance as well as a free Mutual Fund Calculator tool to help you make an informed decision.