13 Sep 2019 20:55 IST

The nitty gritty of debt mutual funds

An explainer on different types of debt funds, which can form an important part of your portfolio

As an investment vehicle, mutual funds provide investment solutions suiting all types of investors. Usually, small investors prefer equity mutual funds as they are easier to understand. But the other two categories of MFs — debt and hybrid — can also play an important role in your portfolio.

Debt funds that invest mainly in fixed income securities are especially critical in forming a balanced portfolio. Here’s an explainer on the different types of debt funds and the strategies they employ.

Debt funds

These funds invest in interest earning securities, whether issued by the government, corporate or public sector entities. These securities include money market instruments (such as certificates of deposit, commercial paper and treasury bills), corporate debentures, PSU bonds, Central and State government securities. Mutual funds also participate as lenders in the call money, repo and tri-party repo transactions.

Debt funds generate income by adapting two strategies — accrual (relying on the interest income) and duration play (benefiting from the capital appreciation by churning the assets based on the interest rate movement in the economy).

Investors with low and medium risk profile can invest in the debt funds. These funds can also be part of one’s portfolio and used for effective asset allocation strategy.

Debt mutual funds, despite claims, are not completely risk-free. Many of the categories under the debt funds are exposed to the credit risk and interest rate risk. Investors should choose the funds carefully from the debt categories suiting their risk appetite, time horizon and financial objectives.

These funds enjoy indexation tax benefit on the sale of units made after three years from the date of purchase.

The classification

In late 2017, market regulator Securities and Exchange Board of India (SEBI) came out with a set of regulations on categorisation and rationalisation of mutual fund schemes to bring uniformity and standardise the attributes of mutual fund schemes across specific categories.

Accordingly, debt funds have been divided into 16 categories based on the type of debt instruments they invest in. They are overnight funds, liquid funds, ultra-short duration, low duration, money market, banking and PSU debt, corporate bond, credit risk, floater, short duration, medium duration, medium to long duration, long duration, dynamic bond, gilt and gilt fund with 10-year constant duration.

Low risk low return funds

Overnight funds and liquid funds are considered as low-risk and low-return categories, as they invest in the very short-term debt instruments.

Overnight funds are the lowest risk category among debt fund categories as they invest in securities with residual maturity of around one day, such as repo, tri-party repo (TREPS), certificate of deposit (CD), commercial paper (CP), Treasury Bill (T-Bill) and cash management bills.

Overnight 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.

Liquid funds invest in debt and money market securities with residual maturity of up to 91 days. They invest mainly in TREPS, CD and CP. Recently, SEBI has mandated that liquid funds must follow only the mark-to-market method of valuation while computing NAVs. This may increase volatility in the returns going ahead. The interest rate risk and credit risk in liquid funds are slightly higher than in the overnight funds.

Surplus short-term money or emergency funds can be parked in these funds. From these funds, one can expect similar or slightly higher returns than from bank FDs.

Duration based funds

There are eight categories here, classified based on the duration of the portfolio of the schemes. They are ultra-short duration, low duration, short duration, medium duration, medium to long duration, long duration, dynamic bond, and gilt fund with 10-year constant duration.

Unlike accrual funds that follow a buy-and-hold strategy, duration funds try to capitalise by churning the portfolio based on the interest rate movement in the market.

The fund manager of the duration funds increases or decreases the duration or average maturity of the portfolio as per his conviction on the interest rate. The prices of the bonds increase when the interest rate in the economy falls, and vice-versa. Also, the longer the maturity of the bond, the more sensitive to the changes in interest rates. So, during a falling rate scenario, the fund manager buys bonds with longer maturity, and vice-versa.

These duration funds are categorised based on the tenure of the bonds held in the portfolio, which is measured using the Macaulay duration, named for Frederick Macaulay, a Canadian economist who undertook a large-scale study of time series behaviour and introduced this concept of bond investment duration. The Macaulay duration, in layman’s terms, is the time taken for an investor to get back all the money he invested in a bond.

For instance, ultra-short duration funds invest in instruments with a Macaulay duration between three months and six months, while long-duration funds invest in debt papers with a Macaulay duration greater than seven years. Dynamic funds have no restriction on the duration, where they have leeway to invest in bonds across maturities.

Duration funds also generate returns from the interest income. These funds take a credit risk and invest in slightly lower-rated securities, in order to generate higher yields.

Since there are limited floating rate bonds available in the market, the funds in the floating rate category manage their portfolios in a manner similar to that of the short duration funds.

Funds managing the portfolio with a short Macaulay duration are suitable for investors with low risk and a time horizon of one to three years. Funds with a longer Macaulay duration are suited for investors with a medium to high risk profile and the minimum time horizon of three years.

Bet on credit risk

One of the debt categories, credit risk funds, invest at least 65 per cent in the bonds rated AA and below. In the rating scale, the bonds rated AAA and AA+ are considered the highest quality paper. Lower-rated paper carries higher coupon rates than higher-rated paper. This pegs up the default risk quotient in these funds. Hence, they are suited for investors with a high risk profile.

Best of both worlds

There are funds following the blend of accrual strategy and duration play including money market funds, corporate bond funds and banking and PSU debt funds.

Money market funds invest in money market instruments with a maturity of up to one year, such as repo agreements, Treasury Bills, certificates of deposits and commercial paper. Funds in the category mainly follow the accrual strategy. Since the average maturity of their portfolio has been kept around one year, they are less impacted by the interest rate risk. The exposure to lower-rated bonds is also low.

Corporate bond funds have the mandate of investing at least 80 per cent of their assets in AAA and AA+ rated corporate debt paper. The remaining part is invested in the relatively lower rated bonds, money market and repo instruments. These funds follow the 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 moderate duration calls when the opportunities arise. Low exposure to sovereign bonds limits the impact of sudden yield movement.

As the name suggests, the 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 remaining portion is invested in government securities and lower-rated bonds. These funds hold mostly the highest-rated debt instruments. In India, the commercial paper and debentures issued by the banks carry the highest credit rating. Also, the debt paper issued by PSUs boasts the highest credit rating and is backed by the Government of India.

Investors with medium risk appetite wanting return higher than the bank FD can consider investing in these funds.

Gilt funds

Two types of gilt funds — gilt funds and gilt fund with 10-year constant duration — are available. They invest at least 80 per cent in the dated securities issued by the 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 those from other debt categories. They are suitable for investors with high risk appetite.