Retail investors in India, more often than not, look at equity funds to build their mutual fund portfolio. Lack of awareness or, possibly, the jargon used in debt mutual funds have kept retail investor interest fairly tepid in debt funds.
Data compiled from AMFI (Association of Mutual Funds in India) show that retail investors’ share in the total debt fund AUM (₹14-lakh crore) is just 4 per cent, or ₹56,468 crore.
What has further dampened investor sentiment towards debt funds is the spate of recent corporate bond downgrades and defaults that have impacted the performance of debt schemes. AMFI data show that retail AUM (assets under management) in debt mutual funds witnessed a decline of around 37 per cent (in absolute terms) in the past two years between December 2017 and December 2019.
But avoiding debt mutual funds altogether, owing to short-term events/losses, is not prudent. These schemes play a critical role in building a sound portfolio across various stages of your life. If equity funds are the way to go to build a portfolio for the long term, beating inflation, debt funds are a must-have in one’s mutual fund kitty to help balance the portfolio’s risk and bring stability in returns across various market cycles and time-frames. Of course, it is important to remember that investments in debt funds are prone to market risk — a part of your investments can erode, unlike that in fixed deposits.
But investing in debt funds carry several advantages. One, debt funds provide access to a diversified set of fixed-income instruments including government securities and debentures. Two, you can easily liquidate your investment in debt funds (normally in T+2 days).
Further, liquid funds provide one of the best avenues to park your emergency funds, offering you instant redemption facility of up to ₹50,000 or 90 per cent of invested amount (credited within 30 minutes to your bank account).
Lastly, debt funds score on indexation tax benefit which lowers the tax burden. In growth plans of debt funds, units sold after 36 months qualifies for long-term capital gains (LTCG) tax at 20 per cent (plus surcharge and cess, as applicable) after indexation benefit on the gain.
So how do you build a debt fund portfolio?
Here, we attempt to explain how retail investors with different risk profiles (based on age) can build their debt fund portfolios.
Asset allocation
Before we delve into the nuts and bolts of creating a debt fund portfolio, it is important to reiterate the relevance of asset allocation. Though clichéd, it is essential that you remember to follow an asset allocation strategy at every stage in your life — ensuring prudent allocation to equity and debt.
One of the easiest ways to decide the equity and debt proportion in one’s portfolio is the ‘100 minus age’ rule — the proportion of equity in your portfolio should be equal to the difference between 100 and your age.
Hence, if you are 35 years old, 65 per cent of your investment should be in equity and 35 per cent in debt.
However, investors can decide their appropriate asset allocation based on other factors such as time horizon, goal and risk appetite.
With asset allocation strategy in place, the next step will be to build a debt fund portfolio. Let us quickly recap some basics of debt funds.
Debt mutual funds invest in interest-earning securities including money market instruments (such as certificates of deposits, commercial papers and Treasury Bills), corporate debentures, PSU bonds, and Central and State government securities. Debt funds generate income by adapting two strategies — accrual (relying on interest income) and duration play (benefiting from capital appreciation by churning assets based on interest-rate movement).
Post the re-categorisation norms of mutual funds implemented in 2018, debt funds are now divided into 16 categories based on the type of debt instruments they invest in.
Debt mutual funds are exposed to credit risk and interest-rate risk.
Essentially, the NAV (net asset value) on your debt fund can rise or fall along with the underlying bond prices. One factor that impacts bond prices is interest rate. Interest rates and bond prices have an inverse relationship. If the interest rates move up, bond prices fall (as investors prefer newer bonds offering higher rates).
Credit risk arises when a debt fund invests in low-credit-quality debt securities which may default on repayment. Over the past 18-24 months, a spate of corporate bond downgrades and defaults have impacted the performance of several debt funds. Mutual funds that marked down their exposure to bonds issued by IL&FS, DHFL, Essel Group, Altico Capital India, Reliance ADAG, Adilink Infra & Multitrading, Vodafone Idea, etc, have seen significant drops in their NAV.
So how do you cut through all this clutter and pick the right debt funds for your portfolio based on your risk profile?
We have divided the investor base into three buckets — investors in the age bracket of 30-50 years (for simplicity, let’s call them ‘goal seekers’), investors nearing retirement, aged 50-60 years (‘wealth preservers’), and investors aged 60 years and above (‘savvy seniors’).
The rationale behind dividing the investors based on age is that the risk-taking ability of retail investors differs in each stage of their life.
We have not considered investors in the 20s age bracket as they are at the start of their career and may follow an aggressive investment strategy of allocating 100 per cent of investments towards equity.
Goal seekers (30-50 years of age)
For investors in this age group, their career path is on course, and the focus is on setting and meeting big financial goals such as buying a house, children’s education and building a retirement kitty.
After following a possibly aggressive spending-and-investment strategy in their 20s, they enter this phase with lot more responsibilities and the need to build risk-diversifiers into their portfolio.
Hence, they need to add/increase allocation to debt at this stage. So, investors in their 30s may allocate around 30 per cent of their portfolio to debt funds, while those in their 40s will have to up their allocation to about 40 per cent.
Of the debt portfolio, two-thirds of the investments can be in relatively low-risk debt funds (listed in the table below). If you have a very low risk appetite, you can consider investing your entire debt portfolio in these funds. If you have a stomach for high risk, you can invest the remaining one-third in relatively high-risk funds such as gilt funds, long-duration, dynamic or credit risk funds (as listed below).
Aside from deciding on the type of debt funds, it is also important to choose your mode of investing — lump sum or a Systematic Investment Plan (SIP). If you wish to stagger your investments, SIPs in debt mutual funds can be quite rewarding, which can be an alternative to bank recurring deposits.
Our back-of-the-envelope analysis of three-year SIP returns for liquid, low-duration, money market and ultra-short-duration debt funds suggests that these funds have managed to deliver higher returns than bank term deposit rates in most periods.
Wealth preservers (50 -60 years)
This stage, often referred to as the pre-retirement phase, is a crucial period. As your regular income flow halts over the next few years, you will have to prep the pitch for a comfortable retired life. So, preservation of accumulated corpus is the primary objective at this juncture, along with generating decent returns. It is the period when investors need to rebalance their portfolio — shifting from risky to less-risky asset classes.
It is wise to hold around 60 per cent of the investment portfolio in debt funds. Of this, two-thirds can be invested in top-performing corporate bond funds, and banking and PSU debt funds. The remaining can be kept in liquid and money market funds.
At this stage, a Systematic Transfer Plan (STP) works well to rebalance and reduce risk in one’s portfolio. STP is a facility offered by mutual funds to transfer your investment from one fund to another.
You can use this option to shift your investments from relatively high-risk funds (equity or debt) to relatively low-risk funds.
Earlier, fund houses allowed transfer only between schemes within the company. Now, you can transfer from a scheme of one particular AMC to that of another.
However, you should take note of the tax implications and exit loads on the transfer.
Savvy seniors (60 years and above)
Finally, it is time to put your feet up and enjoy a retired life. While the very thought of it is comforting, sound financial planning is imperative to enjoy a good lifestyle and meet exigencies.
Remember, you no longer earn a regular income.
The risk appetite of investors is the lowest at this stage. Hence, 80-100 per cent of your mutual fund investments can be in debt funds. Of this, one-third can be kept in top-performing banking and PSU debt and Money market funds, while the rest can be parked in liquid and overnight funds.
Investors wanting regular income can opt for a Systematic Withdrawal Plan (SWP) in the growth option of debt funds. For tax-efficient returns, investors can go for SWPs after holding the units of debt funds for more than 36 months (which qualifies for indexation benefit).
For the cautious
Here, we list some of the debt fund categories that are exposed to relatively low credit risk and interest-rate risk. These funds focus on high credit quality, short-to-medium maturities and high liquidity.
Overnight funds : They invest in securities with a residual maturity of around one day, such as repo, tri-party repo (TREPS), certificates of deposit (CDs), commercial papers (CPs) and Treasury Bills (T-Bills). Overnight funds carry very low credit risk. Further, given their one-day maturity, the interest-rate risk in these papers is almost nil.
Liquid funds : These schemes invest in debt and money market securities with a residual maturity of up to 91 days. They invest mainly in TREPS, CDs and CPs. The interest-rate risk and credit risk in liquid funds are slightly higher than that in overnight funds. Surplus short-term money or emergency funds can be parked in these funds.
One can expect similar or slightly higher returns than bank FDs from these funds.
Money market funds : They invest in money market instruments having a maturity of up to a year, such as repo agreements, T-Bills, CDs and CPs. Funds in the category mainly follow the accrual strategy.
Since the average maturity of their portfolio has been kept around a year, they are less impacted by interest-rate risk.
Their exposure to lower-rated bonds is also low.
Corporate bond funds : These funds have the mandate of investing at least 80 per cent of their assets in AAA and AA+ rated corporate debt papers. The remaining part is invested in relatively low-rated bonds, money market and repo instruments. These funds follow a blend of both strategies — accrual and duration play. Most of the funds in the category maintain an average maturity of around three years and take tactical duration calls when opportunity arises.
Banking and PSU debt funds : These funds invest at least 80 per cent in debt instruments of banks, public sector undertakings, public financial institutions and municipal bonds. The remaining portion is invested in government securities and lower-rated bonds.
These funds mostly hold the highest-rated debt instruments. They are also a good play on rate movement on the shorter end of the yield curve.
For the risk-takers
Here, we list some of the debt fund categories that are exposed to relatively high credit risk and interest-rate risk.
These funds are suitable for those with a high risk appetite and an ability to bear greater volatility in returns.
Long-duration funds: As per SEBI’s categorisation norms, these debt funds have to invest in debt and money market instruments such that the duration of their portfolio is more than seven years.
As longer-duration bonds are more sensitive to interest rates, you are more prone to interest-rate risk in these funds.
Gilt funds: They invest at least 80 per cent in dated securities issued by Central and State governments. They are almost default-free investments as they invest in bonds with sovereign guarantee. However, they are exposed to interest-rate risk.
Fund managers of gilt funds actively churn the duration of the funds based on the interest-rate movement in the market.
Hence, the returns of these funds are more volatile than that of other debt categories.
Dynamic bond funds: These schemes have the flexibility to juggle between short- and long-term debt instruments. Active management of duration by the fund managers helps these funds contain the downside better in a volatile market, while making the best of bond rallies in upbeat market phases. Given that funds in this category mostly invest a major portion of their assets in high-rated bonds and government securities, credit risk is usually relatively low.
If you have a moderate risk appetite, dynamic bond funds are a good option.
Credit risk funds: Credit risk funds invest at least 65 per cent in bonds rated AA and below. In the rating scale, the bonds rated AAA and AA+ are considered highest-quality papers. Lower-rated papers carry higher coupon rates than higher-rated papers. This pegs up the default risk quotient in these funds.
Hence, they are suited for investors with a high risk profile.