Each category of debt fund is suitable for a specific need over a specific time period
Debt allocation is that part of the portfolio where the investor needs the funds in 1-3 years and cannot handle volatility in that portion
More and more retail investors are now buying debt funds. Over 50% of the debt fund assets come from retail investors, according to data from the Association of Mutual Funds in India, and the number is growing. If you are looking to invest in debt funds but so far have only dealt with fixed deposits, you may find it overwhelming to sift through the 16 categories of these funds. A good place to start making sense of the maze is to map out your expectations from your investments. We tell you how to pin down your needs, and then give you a GPS to navigate to those points through suitable funds.
Know your needs
The asset allocation between safety and growth should be the first mapping point for you. “Debt allocation is that part of the portfolio where the investor needs the funds in one to three years and cannot handle volatility in that portion," said Renu Maheshwari, CEO and principal advisor at Finzscholarz Wealth Managers LLP.
At the next stage, get to the specifics. The risks from interest rate movements and credit quality of the portfolio determine the safety of the investment. The higher the average maturity or duration of the portfolio, greater will be the interest rate risk leading to higher volatility in returns. The thumb rule that the investor’s investment horizon should be at least as much as the average maturity of the portfolio will help mitigate this risk to a great extent. The credit risk can be estimated from the credit rating and the issuer profile. “What we like to include in investors’ portfolio are debt funds that have minimal interest rate risk and very high credit quality," said Shyam Sunder, managing director, PeakAlpha Investment Services Pvt. Ltd.
Assessing the expected return and past performance comes next. For this, you need to understand the trade off for higher returns. A fund may be taking higher interest rate risk, which means greater volatility in net asset values (NAVs), or higher credit risk for higher returns, pushing up the possibility of making a loss. Run some checks to evaluate risks such as those from concentration. A portfolio where the exposure to a single security is not more than 2-3%, unless it is a government security, bank- or PSU-issued instrument is a good check to have. A PSU or bank instrument can also face a downgrade which will, in turn, affect its value. But there may not be a default given the quasi-government status. Similarly, recent events have shown the importance of evaluating the exposure that the fund may have to a single group, though this information may be tough to come by.
Align funds to needs
“The journey of building a mutual fund portfolio begins with articulating a need that is converted into a goal and then a fund is identified that fits the role," said Sunder. Here are a few common needs that most households have and the debt fund categories that can meet them.
Liquidity: There is some portion of the portfolio that you may need immediate access to. This may be to meet your regular expenses, for emergencies, to meet goals in the near future or to park funds for a short period before deploying them into long-term investments. Liquid funds are the best option for such needs.
“We recommend that all income should first come into liquid funds and money should be transferred from there using the insta-cash facility to meet expected expenses," said Gajendra Kothari, managing director, Etica Wealth Management (P) Ltd. “The difference in the returns from a savings bank account and a liquid fund is too marked to be ignored and it ensures even your idle money is working for you," he added. The one-year return from liquid funds has been over 7%, while savings bank accounts typically give 3-4%.
For slightly longer goals of 3-6 months, consider ultra-short funds. They give marginally higher returns than liquid funds, and can be used for needs that are predictable and are, typically, larger in ticket size. These include expenses such as parking funds for education fees, vacations, advance tax planning, a portion of the emergency fund and the like. “We encourage investors to build big-ticket expense money throughout the year. The destination for this would be a typical ultra-short fund," said Sunder. For goals of up to one year, low-duration funds are an option.
Stability: When goals come closer, it is prudent to reduce exposure to riskier asset classes such as equity and increase the allocation to debt. You may choose a fund depending on the years remaining to the goal. “If the goal is one-two years away, we look at high-quality short-duration funds and banking and PSU funds where the credit risk is negligible. The holding period is too short to recover if there is a credit event," said Kothari. If there are three years to the goal, then a short-duration or corporate bond fund, including banking and PSU funds, with a tenor of not more than two to two and a half years will be suitable. “If the macros are right we may consider a medium duration fund for longer-term goals," said Maheshwari.
Income: The dividends earned on a debt fund cannot be the source of predictable regular income. But a systematic withdrawal plan (SWP) is a mechanism that can be used to create regular flow of money from mutual funds. Kothari uses debt funds to structure regular income for investors through SWPs.
“The first bucket of money required for the immediate one year is held in liquid funds where there is no exit load, the next bucket holding money for the subsequent two years in a short duration fund and the next bucket holding another two years’ worth of money in a medium-term fund. Beyond this period, the funds can be held in equity and moved to debt funds to refill the buckets," he explained.
Accumulation: Debt as an asset class is not suitable to create wealth over the long term. But sometimes you may be unable to invest in equity either because of adverse macroeconomic conditions or if valuations are high or because you already have too much exposure to equity. In such cases, short-duration funds and corporate bond funds that reflect the investment tenor and risk profile of the investor may be considered, said Sunder. These funds can boost returns.
Kothari recommends dynamic bond funds, AAA corporate bond funds and some exposure to credit risk funds for a horizon of three to five years for tax advantage relative to fixed deposits, for those interested in wealth preservation.
Tactical allocation: Tactical allocations to long-term gilt funds can be a portfolio return booster when conditions are favourable. Reading the indicators correctly to time entry and exit into the funds is important. “We use it very selectively for the more evolved debt investor because the volatility can be very high," said Kothari. Similarly, credit risk funds may be considered in situations of improving economic conditions to benefit from re-rating of companies.
With a little planning, debt funds give you the benefit of indexation that are available on taxing gains on holdings of over three years. Define your needs to be able to identify the best fit and remember to periodically review the funds’ portfolio and performance to ensure they remain consistent to the initial proposition.