The past year saw significant volatility in equity markets due to rising interest rates and inflation worries globally. With already a couple of months into 2024, debt markets are expected to continue witnessing shifts. In this article, take a look at some key factors that investors need to consider to navigate the debt market successfully in the new year.
Understanding interest rate movement
One of the biggest influences on debt markets is the movement of interest rates. The Reserve Bank of India (RBI) has raised key policy rates by 190 basis points over the last few months to tame inflation. Most analysts expect the RBI to pause rate hikes going forward as inflation cools off. However, interest rates are still expected to remain on the higher side in 2024 compared to previous years. This has important implications for debt funds. Funds that invest in instruments with shorter maturities will be impacted more by rising interest rates in the short term. Their net asset values (NAVs) may temporarily decline. However, they also stand to benefit as rates stabilize or start falling. On the other hand, long duration debt funds will see lower volatility but can face higher interest rate risk if rates continue rising for an extended period.
Evaluate credit risk appropriately
Apart from interest rate risk, credit risk is another key factor to monitor in debt funds. With the general slowdown in economic activity, there are concerns about rising defaults across some debt-laden sectors. Investors must carefully study the portfolio and investment policies of debt funds to understand their exposure to lower rated papers that carry higher credit risk.
Schemes with higher exposure to public sector bonds or AAA rated corporate papers will be relatively safer. However, the returns may be more moderate compared to funds investing in higher yielding but riskier corporate bonds. For conservative investors, short term debt funds with high-credit quality portfolios may be suitable to balance returns and safety.
Focus on portfolio, process and track record
Beyond fund category selection, investors must diligently evaluate the investment process, credit research capabilities, and past performance track record of the fund house and scheme. This will give a sense of the fund manager's ability to generate risk-adjusted returns over different interest rate cycles.
Larger debt schemes with adequate portfolio diversification tend to have lower default risk than smaller ones concentrated in few holdings. Additionally, the portfolio's average maturity and credit quality profile must align well with one's risk tolerance and time horizon.
Systematic investment for smoothening returns
Debt funds carry mark to market risks that can lead to NAV fluctuations in the short term. To mitigate this, investors are recommended to follow a systematic investment plan (SIP) approach across 1-3 debt funds based on their goals and risk profile instead of lump sum investments.
SIPs help achieve rupee cost averaging by investing equal amounts regularly. This process smooths out the impact of short-term market volatility and locks in units at different NAVs over time. It also ensures discipline in investing surplus cash flows every month rather than market timing.
Conclusion
By factoring in prevailing macroeconomic conditions and funds' characteristics, investors should be able to thoughtfully build a debt portfolio via short term, long term and dynamic funds to earn competitive risk-adjusted returns in 2024. Factors like interest rate outlook, credit quality, portfolio diversification and fund manager credentials must be prioritized to mitigate downside risks in the debt market. Regular SIPs help accumulate these steady income-generating assets for meeting different financial goals over time.
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