Debt mutual fund universe is very broad and it offers many investment opportunities for different requirements. Contrary to popular perception, debt mutual funds are not meant only for conservative investors. There are various debt funds that are suitable for even those with an aggressive risk profile. Choosing the right debt fund matching one’s requirements is very important.
However, the task is more complex than selecting an equity fund, due to the complex nature of debt markets and various economic factors that determine the fortunes of debt funds. Investing in debt funds (at least in certain categories) solely on the basis of past performance can be tricky.
Before getting into the details, let us refresh our memories about debt and debt mutual funds. By definition, debt is a state of owing something, it can be money, service or other things. When anyone lends/invests money with a person/organization/bank through an agreement where you will be earning some interest, this arrangement can be called a debt investment. A debt mutual fund invests in a pool of debt securities like bonds, debentures, and so on. These securities offer a fixed rate of interest to the fund.
A debt fund can generate returns/income primarily from two sources: a) Interest earned from the securities held in the portfolio, b) Capital Gains accrued due to interest rate movements. Some debt funds try to generate returns only from interest income while others follow a blended approach to generate returns from both interest as well as capital gains. Another distinction in debt funds is based on the tenure of the securities held in the portfolio: short term or long term.
Debt funds carry two kinds of risks: credit risk and interest rate risk.
Credit risk is the risk of default on a debt security. It may arise if the borrower fails to repay the money on maturity. The extent of credit risk in a security can be gauged by the credit ratings assigned to it. So, when a security of highest credit rating goes to market to borrow money, it will offer lower rate of interest because it has a lower probability of defaulting on repayment. A security with lower credit rating will have to offer higher rate of interest because it has higher probability of defaulting on repayment.
Interest rate risk is the risk that arises from fluctuating interest rates. When interest rates go up, market value of securities comes down. In other words, there will be a capital loss. The opposite scenario takes place when interest rates goes down: the market value of the securities goes up or capital gains are made. The quantum of this risk is defined by the duration (tenure) of the security/debt fund held. The longer the duration, the higher the risk. The shorter the duration, lower the interest rate risk.
These risks also bring opportunities for the investors. They can invest in funds which try to optimize returns by adding certain degree of risk to their portfolios. Since there is no single debt fund category through which one can take exposure across the segments, the ideal way to build any debt portfolio is by following a laddered approach or spreading investments across tenure (duration) and credit quality in the portfolio.
It can be achieved by adding schemes of different duration in the portfolio. Similarly, adding schemes of highest to moderate credit quality in the portfolio. This strategy will ensure stability to the portfolio, along with generating good returns in the long run, and also help to spread the risk and investing across the debt spectrum.
Now, we will proceed to our topic of a model allocation for aggressive investors with investment horizon of at least three years:
Short Term Funds
As the name suggests, the short-term debt funds invest in securities with short tenors that have low interest rate risk. The contribution of interest income from the securities held is the main source of income for the fund. This category generally maintains good credit quality portfolio. The schemes with higher credit quality portfolio along with stable performance over long term should be selected. The debt allocation towards this category can be made to be around 35-40 per cent.
Credit Risk Funds
As the name suggests, these schemes take credit risk. By definition, credit risk funds have to invest at least 65 per cent of their portfolio in less than AA-rated securities. In other words, these funds will invest in securities of lower credit quality. Since most of the portfolio holdings will be in lower credit paper, credit risk funds will be able to offer higher yields/returns.While selecting a scheme in this category, one should go with schemes which have a longer track record of stable performance and decent scheme size. Allocation towards this category can be around 35-40 per cent.
Dynamic Bond Funds/Long Duration Funds
The dynamic bond schemes, as the name suggests, are dynamic in terms of the composition & maturity profile. In this category, the fund manager takes tactical calls on the interest rate movements and actively manages the duration of the scheme. These schemes work the best in a declining interest rate environment. To illustrate, in a rising interest rate scenario the fund manager will bring down the duration of the fund to minimise the negative impact and in a declining rate scenario, the duration of the scheme will be increased to maximise the gains. This strategy can also be called as duration play. The schemes which have been consistent in their approach of making changes in the portfolio should be selected. Allocation towards this category can be around 30-35 per cent.