Factors to be considered before investing in FMP - II

Factors to be considered before investing in Fixed Income Funds

In continuation with our previous topics, this note will explain the Factors to be considered before investing in Fixed Income Funds.

There are many factors investors should consider while investing in Fixed Income Funds. We will break the same into 2 parts

1. Portfolio Related Factors
2. Qualitative Factors

In this article we will cover Portfolio Related factors

1. Performance/Returns - An investor should check funds returns over different time periods, like six-months, one-year, three-years, five-years, returns and since inception. It is important to check the returns since the current fund manager has taken over. Also the performance should be compared with the funds benchmark. The funds’ performance should be checked vis-a-vis the performance of other funds in the same category. Also, make sure to check only the growth option of all the funds to make a meaningful comparison as different dividend payment dates of different funds would provide an unclear picture for comparison purposes.
2. Credit Quality of Portfolio - Credit quality of a debt investment is the most important factor for any investor. The overall credit quality of a debt fund will depend on the credit quality of the securities in the portfolio. Different debt funds invest in different debt securities with varying degree of credit quality, ranging from risk-free government securities to high-risk corporate securities. Though credit ratings do not guarantee against any default in payments and are not 100% foolproof either, the relative credit risk of a bond gets reflected in the ratings assigned to them by the independent rating companies such as Crisil, ICRA, CARE, Fitch and Brickwork.  Debt Instruments which are considered to be the safest from credit risk point of view are given the highest credit rating of AAA for longer duration or A1+ for shorter duration. The lower the ratings are for the securities of a debt fund, the riskier the fund becomes for you to invest. Debt funds which invest in lower-quality securities can potentially deliver higher returns, but will also be vulnerable to some level of default risk. So, the investors should choose debt funds with better asset quality.
3. Investment Objective of the Fund – Investors should check the investor objective and asset allocation strategy of the fund. This will help the investor analyze the type of debt instruments and duration of these instruments the fund will actually invest in.
4. Average Time to Maturity - A bond fund carries a weighted average time to maturity, which is the average of the current maturities of all the bonds held in the fund. The longer the average maturity, the more sensitive the fund tends to be to the changes in interest rates. Hence choose lower average maturity funds if you risk profile in lower.
5. Duration - Though duration and maturity sound similar, they have different meaning. Duration measures how much a bond’s price will rise or fall with a percentage fall or rise in interest rates and is calculated in a similar manner in which maturity is calculated. A fund with an average duration of 6.74 years (or just 6.74) will theoretically appreciate 6.74% in value with a 1% fall in interest rate, keeping all other factors constant. Hence choose funds with higher duration incase you want to take advantage of fall in interest rates and vise versa.
6. Yield to Maturity - Yield to Maturity (or YTM) is the annualized rate of return that an investor earns on a fixed income instrument, if the investor purchases the bond today and holds it until maturity. Average yield to maturity of a debt fund is the average of the current maturities of all the bonds held in the fund. Investors need to factor in the credit risk, risk of default associated with the issuers, and how that risk might affect the safety of your investment.
7. Standard Deviation - While a debt fund may generate a higher return, the return may be the result of potentially higher risk. Standard deviation calculates the sensitivity of a security or a fund. The higher the standard deviation, the higher the volatility risk of the fund.
8. Sharpe Ratio - Sharpe Ratio calculates risk-adjusted performance of a portfolio. Sharpe Ratio = (Portfolio Return – Risk-Free Rate) / Portfolio Standard Deviation The higher the Sharpe Ratio, the better the debt fund has performed after being adjusted for its risk.
9. Expenses - A fund charges expenses and fees for managing your investment. These expenses are a certain percentage of the total assets managed by the fund and hence are termed as the Expense Ratio. The lower these expenses are, the better it is for you. But, at the same time, you should focus more on the returns generated by a fund and less on the expenses.
10. Exit Load - it is important for investors to check the exit load before making the investment, as if the investor exits before that date he will have to bear the exit loads, which will reduce overall returns of the investor.

We will be explaining the qualitative factors investors should consider while investing in fixed income funds in our next week article.

Mutual fund investments are subject to market risks, read all scheme related documents carefully.