Quality of bonds is the most important factor for me while selecting a debt fund.

However, only one factor might not suffice while selecting a bond fund. I prefer also looking at the following before investment:

1. Quality of Bonds: I invest in Bonds because it provides more security (lower risk) than stocks.
   • I would prefer investing only in high quality bonds rated AAA, AA+ or AA but not lower than that.
   • A lower rating means the company is at a much higher risk and does not serve my purpose of investing in bonds.
2. Yield to Maturity: YTM or Yield to maturity is important to understand the returns of the bonds.
   • Yield to maturity (YTM) is the total return expected on a bond if the bond is held until it matures.
   • Also, while YTM is a long-term bond yield, it is expressed as an annualized rate of return.
   • If two bonds of similar quality and duration have different YTMs, I would opt for the higher yield since the risk is same.
3. Time to Maturity: Time to maturity is the tenure post which the bond will mature and should align with my investment goal / horizon.
4. Duration of Bonds: It is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. The bond’s duration is different from time to maturity, so we should not get confused between the two.
   • Bonds’ investment value can be most affected by credit risk (default) and interest rate risk (interest rate fluctuations). Duration is used to quantify the potential impact these factors will have on a bond’s price because both factors will affect a bond’s expected YTM.
   • As maturity increases, duration also increases and the bond’s price becomes more sensitive to interest rate changes.
   • Bond prices are said to have an inverse relationship with interest rates. Therefore, rising interest rates indicate that bond prices are likely to fall, while declining interest rates indicate that bond prices are likely to rise.
   • Let me explain the two basic types of bonds:
     1. Zero Coupon Bond: Duration is equal to its time to maturity.
     2. Plain Vanilla Bond: Duration will always be less than its time to maturity.
     3. Generally, the more higher the duration, the more the price of a bond will drop as the interest rates rise (and the greater the interest rate risk).
   • Talking about a couple of types of Duration,
     1. Macaulay duration: It is the weighted average time until all the bond’s cash flows are paid and is measured in years. The Macaulay duration helps an investor evaluate and compare bonds independent of their term or time to maturity, by accounting for the present value of future bond payments.
     2. Modified Duration: It measures the expected change in a bond’s price to a 1% change in the interest rates and measured in percentage terms (not in years).
     3. Not getting into the formulas as it may become too complicated, and since most of these details are available online for us to directly use.
   • I also prefer working on long term or short term strategy on bond duration (depending on my requirement) before investing.

Advice: Debt is a good thing, but only if plan it properly. Debt mutual funds take care of the investment bit and invest in the different type of bonds. However, it is up to us to identify our requirement and invest accordingly. Also, ensure all factors are taken into consideration before investing !!