It is all about investing some money in debt funds because the asset allocation theory exhorts you to be  well-diversified, says the cynic. But is it that simple to invest money in mutual fund schemes that invest in fixed income instruments? You have to have a clear idea of the expected returns, diversification, and then, you cannot afford to take undue risks – yes, you read it right. Debt funds do come with some risks and how diversification manages it.

Here are 5 facts you need to know when it comes to investing in debt funds:

1. You may lose some money in debt funds

Don't believe this? Ask those investors who invested in long term gilt funds when the 10 year g-sec yield was quoting at 7% and exited when the yield went closer to 9% in no time. When the interest rates go up, the bond prices fall, which leads to loss of capital. If the upward movement in interest rate is swift, long term gilt funds typically show losses. Still not willing to buy this point – check one month negative returns of gilt funds – negative 0.81%, all thanks to swift upward movement in yields.

2. SIP may not work in debt funds

AMCs sell mutual funds through SIP. But why does SIP not work with debt funds? Wait – let's see in detail. In long term gilt funds, you have to be sure of your entry and exit. You may not benefit much through SIP. Ask a fund manager worth his salt and he will say, buy if 10 year gilt is above 8.75% and sell if it is below 7%. If you do an SIP in long term gilt fund, you may iron out the volatility, but may not benefit in terms of returns, the way it happens in equities. However, if you are in accrual focused funds with not much interest rate sensitivity, the SIP works.

3. Not all funds make money the same way

In equity mutual funds, we have seen all schemes doing well in rising markets. However, it is not the case in the case of debt funds. When the interest rates rise, liquid funds stand to benefit and long term gilt funds lose, and vice versa. This happens because the liquid funds are short term investors and keep an eye on any opportunity for deploying money at higher coupon when interest rates rise. Long term gilt funds typically invest in long term government securities and are sensitive to changes in interest rates. When rates rise, the net asset value (NAV) of these funds bleed as they have to face capital losses.

While accrual focused funds make extra money by buying into low rated papers, duration focused funds make extra returns by buying into long term bonds in falling interest rate regime. For example, an accrual focused scheme may choose to buy papers with A rating or structured obligations to boost returns to investors. Here, the fund manager may be taking extra credit risk after conducting due diligence. Long term gilt funds may choose to buy papers of longer time to maturity – typically 25 to 30 years when the interest rates are in down cycle.

4. Each scheme comes with different risk level

Never jump into a scheme that recorded double digit returns. Though some investors understand interest rate risks due to volatility of returns, credit risk is typically undermined. In accrual products, there are schemes that take varying degrees of risks. Banking and PSU debt funds typically invest in instruments that come with almost no credit risks. These funds offer lower returns as compared to schemes that invest in instruments with A rating or in structured obligations. Bond opportunities funds or corporate debt opportunities fund typically take that extra credit risk as compared to banking and PSU funds, though in most cases both these categories may focus on yields rather than duration.

5. Expense ratio matters

This may sound a bit weird to many, especially if you are an equity fund investor. In an equity fund, a fund with higher expense ratio may substantiate it with higher returns – alpha over market returns. However, in bond funds there is a limit for that excess returns over market returns. It makes sense to be with low cost funds as fund manager skills are limited when it comes to upsides. A low cost fund with a focus on risk management is a better bet than a high cost fund in bond markets as the return generation capacity is limited.