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Interest rates have begun to decline from their recent highs, with the MPC (Monetary Policy Committee) pausing its rate hikes and inflation falling steadily in recent months. The yield on the 10-year government security, which is the benchmark for bond markets, has dipped from 7.5 per cent in February 2023 to about 7.06 per cent now.
But for investors looking to earn higher yields, there is still a window of opportunity in some market segments. One such segment is the bonds issued by banks and PSUs. Though the g-sec yield has dipped to the 7 per cent mark, AAA-rated bonds from PSUs still offer a 40-60 basis point spread over g-secs of similar tenure. With strong credit offtake and intense competition for deposits, banks have been aggressive borrowers, raising Additional Tier-1 (AT-1) and Tier-2 bonds at 7.5-8.5 per cent to supplement their capital. For retail investors looking to participate in this opportunity, debt funds investing in PSU and bank bonds offer a good combination of high yield with good credit quality. Kotak PSU and Banking Debt Fund is a good pick in this space.
Good record
Within the category, Kotak Banking and PSU Fund has a good performance record. It’s trailing returns for one year, five years and 10 years are well ahead of the category average. It scores well on rolling returns too, which are more relevant for investors. On a rolling return basis, the regular plan has managed an average annual return of 7.03 per cent across multiple rate cycles since 2006, with a maximum return of 12.6 per cent and minimum of 2.1 per cent for one-year periods. The direct plan, which was launched in 2013, has fared even better, with average returns at 8.2 per cent and the maximum and minimum at 12.8 per cent and 2.7 per cent respectively for annual periods.
Balanced portfolio
Lately, Kotak Banking and PSU Debt Fund has been dividing its allocations between AAA- or A1-rated PSU and bank bonds and g-secs to maintain a high-quality portfolio. As of end-May, the fund owned a 77 per cent exposure to PSU/bank bonds and commercial paper, with a 19 per cent weight in g-secs. In terms of rating profile, 88 per cent of the portfolio was invested in AAA- or A1-rated corporate bonds with a lower 8.8 per cent weight in AA-rated bonds.
The corporate bond exposure consists mainly of bonds from financial institutions such as NABARD, PFC, REC, DME Development (NHAI subsidiary) and SIDBI, and a few private sector names such as HDFC, ICICI Bank and Axis Bank. It held Tier-2 bonds from banks such as SBI, Bank of Baroda, Indian Bank, PNB and Canara Bank. The fund also had a 5.2 per cent weight in AT-1 bonds.
AT-1 bonds are risky because they are perpetual by design and have features that allow the issuing bank to skip coupon payments or write down principal if their capital falls short. But owning a diversified exposure to such bonds through the fund route allows investors to benefit from their high yields while curbing risk. Kotak Banking and PSU Debt fund has, moreover, invested in AT-1 bonds from PSUs such as Canara Bank, Union Bank and Bank of Baroda. The probability of a skipped call or coupon/principal write-offs in PSU banks is lower, given the government backing.
This mix of holdings resulted in the fund having a relatively high portfolio YTM (yield to maturity) within its category, at 7.73 per cent by end-May.
Rate risks
While most funds in this category maintain average portfolio maturities of one-five years, the Kotak fund had a long average maturity of 10 years by end-May 2023. This could perhaps explain its high returns in a falling rate environment. This exposes investors in this fund to interest rate risk. Should interest rates spike up again due to inflation resurfacing, the fund’s returns could take a bigger hit than rivals with lower maturity. But Kotak has tried to balance duration risk by owning a significant exposure (about 17 per cent) to floating rate bonds from the Government of India and DME Development. Rates on these bonds will get reset upwards or downwards based on swings in market interest rates.
The fund’s total expense ratio was 0.81 per cent for the regular plan and 0.37 per cent for the direct plan. The fund managed assets of ₹6,410 crore by end-May 2023. These were at the higher end of the category range of 0.37-0.81 per cent for regular plans and 0.15-0.43 per cent for direct plans.
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