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Debt mutual funds are often sold as an alternative to bank fixed deposits. But they are not entirely risk-free. Though debt funds may not be as risky as equity funds, they do come with the possibility of capital erosion.
Over the past 12-15 months, a spate of corporate bond downgrades and defaults have impacted the performance of debt mutual funds. Bonds issued by IL&FS, DHFL, Essel Group and Reliance ADAG Group were all been downgraded sharply. This led mutual fund companies marking down such distressed assets in the portfolio of the schemes that held them. Many debt funds, including liquid funds, witnessed a significant drop in their NAV (net asset value).
Given that the credit quality issue in debt instruments has been persisting for some time, investors can consider debt fund categories that focus on high credit quality, short-to-medium maturities and inherent high liquidity. These include overnight funds, liquid funds, money market funds, corporate bond funds, and banking and PSU debt funds.
Investors can choose debt schemes which have diversified allocation to different types of debt instruments. Such diversification offers liquidity while mitigating credit risk.
Overnight funds
Overnight funds are considered to be of the lowest risk among debt funds as they invest in securities with residual maturity of around a day, such as repo, tri-party repo (TREPS), certificates of deposit (CD), commercial papers (CP), Treasury Bills (T-Bill) and cash management bills.
These funds carry very low credit risk as the default risk in the above-mentioned papers is very low. Further, given their one-day maturity, interest rate risk in these papers is almost nil. (The prices of bonds increase when the interest rate in the economy falls, and vice versa. Changes in interest rates inversely impact bond prices. This is known as interest rate risk.) Investors who want to park their idle money for a short term, say, a day or a month, or to manage their emergency funds, can consider investing in overnight funds.
Liquid funds
Liquid funds invest in debt and money market securities with a residual maturity of up to 91 days. They invest mainly in TREPS, CDs and CPs. Recently, SEBI mandated liquid funds to follow only the mark-to-market method of valuation while computing NAVs. This may increase the volatility marginally in their returns going ahead. The interest rate risk and credit risk in liquid funds are slightly higher than 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.
Money market funds
Money market funds invest in money market instruments having a maturity of up to a year, such as repo agreements, Treasury Bills, CDs and CPs. Funds in this category mainly follow the accrual strategy (relying on interest income).
Since the average maturity of their portfolio has been kept around one year, they are less impacted by interest rate risk. The exposure to lower rated bonds is also low.
Corporate bond funds
Corporate bond funds have the mandate of investing at least 80 per cent of their assets in AAA and AA+ rated corporate debt papers. The balance is invested in relatively lower rated bonds, money market and repo instruments.
These funds generate income by adopting both strategies — accrual (relying on interest income) and duration play (benefiting from capital appreciation by churning assets based on interest rate movement in the economy).
Most funds in this category maintain an average maturity of around three years and take tactical moderate duration calls when opportunities arise. Large allocation to the highest-rated papers mitigates credit risk.
Banking and PSU debt funds
As the name suggests, banking and PSU debt funds invest at least 80 per cent in debt instruments of banks, public sector undertakings, public financial institutions and municipal bonds. The balance is invested in government securities and corporate bonds.
In India, the debt papers issued by PSU companies (which are backed by the Centre) and banks boast a relatively higher credit rating. These funds follow both accrual and duration play strategies.
Investors with medium-risk appetite who want higher returns than bank FDs can consider investing in money market funds, corporate bond funds, and banking and PSU funds.
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