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First came the payment defaults by non-banking finance companies which mutual funds had lent to, then came negative returns in open ended debt funds, then came capital loss in case of some fixed maturity plans and now SEBI has come out with new guidelines around liquid funds with the objective of to protecting investors.

While these guidelines will help smoothen out some of that risk in debt mutual funds and perhaps soften the blow of such credit events on the net asset value, as an investor you still have a responsibility to do the hard work of choosing carefully. What are you choosing? Firstly, your advisor and then with your advisor the debt fund that fits your requirement.

Its not that hard, but it does require you to put in an effort, else you will face the blow of lower returns in periods of slower economic growth and credit cycle downturn.

Here goes, a simple checklist for you to consider while choosing that debt fund.

Step 1 – Get a good advisor

I have articulated this several times, it is practically impossible for the average investor to understand and filter through hundreds of schemes and arrive at the one best suited for their needs. What you would rather do is look for a trustworthy financial advisor who can help you filter through these schemes. The advisor will not only choose the right debt fund but also help you understand which goals are best achieved with the help of these funds, how much to invest and for how long.

Step 2 – Don’t pick high returns

The worst thing to do in debt funds is to pick one that gives you the highest return. The high return comes with taking some risk and while this risk will not be very visible all the time, if and when it does playout you stand to lose some serious money. If not on the basis of return then what? Follow the next few steps.

Step 3 – Pick open ended schemes

With your advisor look only for open ended debt funds and not fixed maturity plans (FMP). The former are funds where you can invest and withdraw money at any point. On the other hand, FMPs lock in your money for 1/3/5 years. If a payment default happens from any security in the debt fund portfolio, in the open-ended fund it will reflects as a negative change in daily net asset value or a fall in price. However, an open-ended structure allows the fund manager to sell the security or add others that can make up for the loss in return. So, if you remain invested loss can get recouped (to some extent at least) by prudent fund management. This is not possible in an FMP and the investors will have to bear the loss of a default in payment by any portfolio company.

Plus, in an open-ended fund you have the flexibility of redeeming your money when you need it.

Step 4 – Portfolio credit rating

Very simply a credit rating tells you the likelihood that the underlying security will default on a payment. A ‘AAA’ rating reflects the highest degree of safety when it comes to payment of interest and repayment of capital. ‘AA’ is also a high level of rating. Avoid anything that is ‘A’ and below if the objective of your debt fund in the portfolio is to provide a safety cushion or stable returns.

Unfortunately, the events that have shaken the faith in debt funds resulted from defaults by AAA securities issued by companies thought to have the highest level of safety. One has to understand that in a growing economic cycle, companies tend to grow earnings, have ample access to refinance and such payments are not an issue. It is only when the cycle turns and the economy starts to degrow (which is the case now for the last 2 years at least) that trouble starts to show up.

Your best bet is still to remain in good quality debt mutual fund portfolios. You and your advisor need to do this homework before investing.

Step 5 – Group level exposure

This next step requires a slightly higher level of research and perhaps you can leave it to your advisor. Usually, any debt fund portfolio will have securities issued by different companies of the same group or the same parent. Often the credit rating profile of the parent rubs off on the subsidiary company also. Hence, if the parent is strong and perceived to be a good quality, the subsidiaries are also lent to with a similar perception. Again, its all good while the going is good.

The risk only shows up when things turn sour and then to have too much exposure or lending to companies of the same group in case of default or even credit downgrade can hurt returns. Hence, a well-diversified portfolio which is not overly reliant on the fortunes of large groups is a better choice.

Step 6 – Check fund features

Ideally you should pick a debt fund with low expense ratio, ask your advisor to check. Along with that, check that the average tenure of the portfolio is in line with your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More period. So, if you want to invest your funds for a short period of 3 months, the average tenure of all securities in the portfolio put together should be roughly 3 months; if your investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More period is 3 years then it should match that or be close to 3 years. This restricts the level of risk you take to match the investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More objective and investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More period. This is a very important step when it comes to market linked investments or investments whose daily value is impacted by change in market prices of the underlying securities.

Step 7 – Fund manager pedigree

This is something only your advisor will be able to help with. Please check and re check the fund manager’s performance history and consistency of returns in a particular type of fund. It does not guarantee future returns, but is simply a guide on what you can expect if things go wrong.  A well-managed portfolio makes all the difference when it comes to fulfilling expected returns.

The final return on the fund will be a combined function of all the variable we have spoken of above. If you only track funds that give you a high return, you will end up with all the risk too. Depending on the maturity profile and credit quality of the debt fund you choose, you can earn anywhere between 7%-8.5% from low to moderate risk debt fund portfolios. Don’t be lazy when it comes to your hard-earned money. Get an advisor, ask the right questions and take out time to understand what matters. Do your homework, it’s your money.