5 steps to build an all-weather debt portfolio

By Larissa Fernand |  17-08-22 | 
 

For an investor who wants to build an equity portfolio but finds the way ahead foggy, there is always the option of investing in an index fund. It's a great way to get started.

When it comes to the debt portion of the portfolio, there is a lot more confusion. Investors tend to stick to the Employee Provident Fund (EPF), Public Provident Fund (PPF), bank fixed deposits or post office schemes.

But there is much more to consider specially in the space of debt funds.

We approached financial adviser DEV ASHISH to draw up a simple step-by-step guide for the individual investor. Here are his suggestions on how to create a low-maintenance, all-weather debt fund portfolio.

1. Prioritise what you need from debt.

All portfolios should have a mix of equity and debt in proportions that are suited for the individual. Having said that, debt is primarily about capital preservation while equity is about returns and growth.

My suggestion is to not prioritise return ON capital on the debt side by taking unnecessary risks. Debt should be about prioritising the return OF capital. When you take unnecessary risks, an undesirable event may blow up in your face, as we saw with certain debt funds in recent times.

2. What a low-maintenance, all-weather debt fund portfolio is NOT.

While the aim is to construct a portfolio that will suffice for all circumstances without too much active intervention, it is NOT a buy-and-forget portfolio.

This is a portfolio that can be held for the long term, without requiring too much maneuvering to handle interest rate cycles or credit events.

By having funds across different maturity buckets but within a narrow and well-defined boundary for duration and credit risks, one can build a reasonably stable debt fund portfolio. This level of diversification not only helps manage the interest rate risk and credit risk but also optimizes and smoothens the return experience of the portfolio over the long term.

This is NOT a maximise-return portfolio. If you follow the below suggested structure, it will never result in the highest-return debt fund portfolio. The aim is to build an all-weather portfolio and not try to maximize returns from debt. There will always be other categories of debt funds that will yield higher returns every now and then. But this will be because of greater risk-taking which most debt investors may not be very comfortable with if they knew how to properly analyze debt fund portfolios.

3. Key features of a low-maintenance, all-weather debt fund portfolio.

  • Maturity Profiles

It should have diversity in maturity profiles. At certain times, lower maturity papers will do well and at times, the longer duration ones. Have a mix so that even if the overall debt portfolio may not be the best performing one in a given scenario, you will never do badly. There will always be something in the portfolio that is working for you. Sounds boring but in debt, this is what works best on a sustainable basis.

  • Credit Risk

If not managed properly, this can backfire in a very ugly way. Uncontrolled credit risk-taking should be a big avoid. Some bit of credit risk is acceptable in the portfolio as that is where extra returns can potentially come from. But this should be limited to a very small allocation of your debt portfolio, maybe 10-15%.

  • AMC level diversification

Don’t invest in all funds from a single asset management company. This helps in controlling the AMC concentration risk. Moreover, all AMCs have their own signature style of managing debt portfolios and risk management processes. Some are conservative, others adventurous. A mix of both, more of the former and less of the latter, should be good.

4. Components of a low-maintenance, all-weather debt fund portfolio.

It should be divided primarily into two buckets.

The Core will be about conservative, reliable options while the Satellite can be about generating potentially higher returns but with higher (though limited) risk-taking in the interest and credit space.

It is perfectly fine to skip the Satellite bucket and have all debt allocation assigned to the Core bucket. Only explore the satellite part if you are willing to take a bit of additional risk, which may or may not work, to generate a bit of extra returns. If you want to keep things simple, stick to Core.

Core

The allocation can vary between 70% and 100%. The exact allocation and weight to each category will depend on the individual risk-return requirements, timelines and investment amount.

  • Low Duration Funds (10-20%)
  • Short Duration Funds (20-40%)
  • Target Maturity ETFs (20-40%)
  • Banking & PSU Debt Funds (20-40%)
  • Corporate Bonds Funds (20-40%)

Satellite

This bucket is about trying to generate higher returns. So this will come with a bit of risk taking which needs to be limited and hence, should have only 0-30% allocation.

  • Dynamic Bond Funds (to actively manage interest rate risk in an attempt to generate alpha)
  • Credit Risk Funds (to take credit risk in search of extra returns)
  • Conservative Hybrid Funds (these have a bit of equity so obvious risks of equity are structurally built into it). 

5. Picking the right schemes within categories.

While picking schemes from the shortlisted fund categories, limit yourself to those from established AMCs, having large AUMs and low expense ratios. Choose schemes which have a reasonably long track record.

Stick to those which have a conservative tilt in managing debt portfolios. Avoid schemes that have a very high exposure to papers below AA+ or similar nomenclatures. Even though we are building a debt fund portfolio for the long-term, the credit risk should be capped to a small exposure. This is because unforeseen credit events can make a high credit-risk strategy backfire big time at precisely the wrong times with no scope or time for recovery or chances of course correction. So don’t get too attracted to the high returns of these funds.

Don’t allow one fund to have more than 30-35% exposure to your portfolio, though it would be better to keep a 25% cap to better manage concentration risks. For smaller portfolios, even just two funds should be good.

Do Note: If you have a considerably large debt portfolio or are unsure as to how to select the right funds, approach an investment adviser.

Dev Ashish is a SEBI Registered Investment Adviser (RIA) and the founder of  Stable Investor. You can follow him on Twitter

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