How to choose a debt fund

By Mohasin Athanikar |  14-01-21 | 
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About the Author
Mohasin Athanikar is an Investment Analyst for Morningstar Investment Adviser India.

Broadly, how can I choose a debt fund? Specifically, I am stuck trying to juggle between duration and yield. How must I decide between the two and what type of fund must I go for?

The choice for an individual fixed-income fund should depend on the fitment of the fund in the overall portfolio context, and the risk-profile of the investor, which in turn depends on ability and willingness of an investor to withstand volatility. The investor should look at the portfolio credit quality and duration, the expense ratio and the exit load (if any). Investors should also look at the past performance of the fund and/or fund manager, to gauge whether the fund has been able to avoid any past downgrades/defaults in the fund highlighting the effectiveness of their credit-assessment process.

  • Know what goes into a debt fund.

Fixed-income based mutual funds invest into securities such as G-secs, SDLs (state development loans), corporate bonds/NCDs, money-market instruments such as CP/CD, T-bills, Repo, etc.

G-secs/T-bills are the safest instruments as they have no credit risk, being backed by the sovereign guarantee of the government of India. SDLs too have almost no credit risk as they are backed by the central government.

Corporate bonds/NCDs do have credit risk and are rated by rating agencies, with ‘AAA’ rating being the safest rating and ‘BBB’ being the lowest investment grade rating, while ‘D’ indicates an issuer in default. Riskier instruments offer a higher yield to compensate investors for the credit risk and relative illiquidity that they are being subject to.

  • No market linked investment, be it debt or equity, is ever risk free.

There are two main risks you should be aware of. Duration (interest-rate) risk and Credit risk.

Interest rate risk relates to the impact of fluctuations or movements in interest rates, on the price of the debt instruments. Bond prices and yields carry an inverse relationship, i.e. if interest rates in the economy are moving up bond prices tend to move down and vice-versa. Prices on bonds with higher tenors are more sensitive to interest rate movements vis-à-vis bonds with shorter tenors.

Credit risk relates to the probability of default or delay in interest or principal repayment by the issuer of the bond. Generally, Government securities and AAA rated (or highest) instruments carry low credit risk vis-à-vis lower rated instruments.

Mutual funds differentiate their fund offerings across categories, by investing with a different mix of such instruments across the rating spectrum, to offer investors a basket of funds with different risk-reward potential.

In a major re-jig in mutual fund categorization in October 2017, SEBI defined 16 fixed-income categories mainly defined along the basis of duration – such as overnight funds (which invest into overnight instruments) to long-duration funds (which invest into long-term G-secs, corporate bonds/NCDs).

Various debt categories carry varying levels of credit and interest rate risk. For instance, categories with a duration of less than one year such as Liquid, Ultra Short Duration, etc. carry very low or negligible interest rate risk, but maybe be subject to some level of credit risk depending on the credit profile of the underlying holdings. Gilt funds primarily carry interest rate risk as securities issued by the central government are considered to be credit risk free, while longer duration funds carry some element of both interest rate risk and credit risk. Credit risk funds would tend to carry low to moderate interest rate risk as they tend to invest in 1 to 3 year papers, but higher credit risk vs other categories as they invest a minimum of 65% in AA and below rated papers.

In addition, there are other risks such as liquidity risk which is the risk of having to sell at a steep discount to fair value, in case of few buyers. Most debt funds tend to maintain some portion of their portfolios in liquid instruments such as cash, G-secs, Treasury bills (or T-bills), repo etc. to meet redemption requirements. Further, higher rated instruments tend to be relatively more liquid and can be sold quickly without any significant impact cost.

It is best to follow a core-satellite approach.

  • Core portfolio. 

The core should be debt funds that are low on both, duration and credit risk. So the core portfolio will be invested into high credit quality (safer) shorter-duration funds to minimize impact due to potential credit and duration risks. Depending on your risk profile, as well as your overall portfolio, you can decide how much to allocate to core and satellite portion of your portfolio.

  • Satellite portfolio. 

The satellite portion of the portfolio can be allocated to credit-risk funds and longer-duration funds.

Longer-duration funds (including gilt, dynamic bond funds) offer a higher yield compensating investors for the interest rate risk and/or credit risk, and present a potential for significant capital appreciation in a falling interest-rate cycle. However, these would deliver subdued performance in case interest rates move north. 

Credit risk funds provide additional yield relative to other shorter-duration funds, as they invest into riskier securities and hence exposure to such funds should be restricted to 10-15% of the fixed-income portfolio to curtail credit risk. 

  • Debt funds are not a substitute for a fixed deposit. 

The assurance on returns that you get from a fixed deposit will not be available with a market-linked product such as debt funds which are marked-to-market on a daily basis. Having said that, debt funds offer a favourable taxation compared to bank deposits for holding periods over 3 years, where in the gains are taxed at 20% (excluding cess and surcharge) post indexation of costs. In the case of fixed deposits, the interest earned is taxed at the marginal tax rate irrespective of the holding period.

  • Be cautious.

Fixed-income funds too are prone to the risk of capital loss, as has been re-enforced by the recent market events over the past two years, which saw significant markdowns in several debt funds following downgrades and defaults of various issuers.

To aid investors in assessing the risk (duration risk, credit risk, liquidity risk) of fixed-income funds, the SEBI has now mandated mutual funds to disclose a dynamic ‘Risk-o-meter’ which could vary every month, depending on the inherent risk of a fund’s underlying holdings.

Investors should also diversify their holdings across two or more funds. Also, diversify across fund houses. This helps you avoid concentration of the interest rate/credit related calls of a fund manager/fund house. 

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