Designing A Debt Mutual Fund Portfolio

The start of year 2020 has not come with great news for bond fund investors in India. After the apex court of India dismissed a review petition on AGR dues filed by Vodafone Idea and Bharti Airtel, the mutual fund industry is staring at around Rs 3,400 crore worth of exposure that could see a default or mark down impacting the net asset values (NAV) of funds invested in these papers. This has come in the wake of an already tumultuous year for bond fund investors.

The year 2019 was a crude shock for many bond fund investors as it almost lost its ‘less volatile’ tag. We saw huge volatility in the bond market due to corporate events that adversely impacted the returns of the bond funds. There were couple of bond funds that saw their NAV dropping in excess of 40 per cent in just 12 months. Besides, there were even funds that went down by 20 per cent in the last one year. Most of these funds are from ‘corporate bond’, ‘credit risk’ or ‘short duration’ category.

In India, retail investors already have lower exposure to bond funds, which makes for about 30 per cent of their portfolio. Of this, 24 per cent is in debt funds and the rest 6 per cent is in the liquid or money market fund. One of the reasons for such lower exposure to debt fund is due to their lower returns in the long run compared to equity dedicated funds. Besides, there is very less clarity on the part of investors’ about how to use debt instruments in their portfolio. The latest credit events have only dented the sentiments of investors towards debt funds.

With this background, a prudent debt portfolio construction and risk management assumes prime importance for a better investing experience and get the most out of a bond portfolio that will help you to achieve your financial objectives.

Building a Debt Portfolio

The building of your debt portfolio should begin with your asset allocation plan, which guides you on how to allocate your investments in different asset classes such as equity, bonds, and money market funds in different proportion. The management of debt portfolios is very different from the management of stock portfolios. Debt portfolios provide regular flow of income and have fixed lives, whereas stocks do not mature, might not provide regular flows of income if the stocks do not pay dividends, and do not have maturity dates, which means uncertainty with regard to future stock prices.

While investing in a debt fund what one looks at is credit rating of the underlying assets based on their respective credit ratings. A higher credit rating indicates that debt security has a higher chance of paying interest regularly along with the repayment of the principal upon expiry of the investment tenure. Apart from that, they also check how the interest rate movement will impact the bond prices.

Now that we have a basic understanding of bonds and bond funds, how can we apply what we have learned to help us select a bond fund that’s appropriate for us? Here are some simple guidelines you might use:



Time Horizon

Find a bond fund that matches your investment time horizon. Your investment horizon will depend upon your goal for which you are investing. For example, if you will need the money in two or three years, then invest in those funds that have same or longer ‘duration’. Your goal can be short-term, medium-term or long-term. Depending upon this you can invest in the following funds:



 Short-Term : For all your short-term needs you can invest in overnight or liquid funds. These funds invest in overnight securities having maturity of one day or money market securities with maturity of up to 91 days. They carry very low interest rate or credit risk and can be safely used for your emergency funds where the need for liquidity can arise anytime and you cannot afford to take any risk. Investors across risk profile can use this to fulfil their short-term needs.

 Medium-Term: While safety and liquidity are your prime concerns when investing for your short-term needs, when you invest for medium-term, returns generated by the instrument become critical. This does not mean that safety takes a back seat. Both safety and returns become equally important. The types of bond funds that satisfy these criteria are low to short duration bond funds, corporate bonds, and banking and PSU funds. Conservative investors should invest in funds that have more than 90 per cent exposure to funds that are investing in instruments that are rated AAA and equivalent. For aggressive investors investing in these funds, it can be a maximum of up to 50 per cent of their entire bond portfolio for medium duration.

 Long-Term: Besides safety and liquidity, it is returns that are crucial for investing for long-term in bond funds. When you invest in a bond fund with the intention of higher returns, there also comes with it the heightened risk. An aggressive investor can invest in dynamic bond funds, credit risk funds or debt-oriented hybrid funds.

Strategies for Long-Term Investment

While constructing bond portfolio for-long term, you can adopt any or of the following three strategies:

 Duration Strategy: Under this strategy you can invest in long-term bonds that benefit from fall in interest rates. As bond prices and interest rate are negatively correlated, a fall in the interest rate leads to rise in the bond prices and vice-versa. These funds are exposed to interest rate risk and if the interest rates move up these funds bear capital losses. Such funds can generate better return in a time when the interest rates are set to move downwards. A dynamic bond fund can be used to play the duration strategy.

 Credit Strategy: Credit strategy is usually the most important consideration for investors looking for high yield. Such funds tend to invest in those bonds that have a higher yield; however, they might be rated lower. Credit spreads tend to be negatively correlated with risk-free interest rates.

 Debt-Oriented Hybrid Funds: This is probably the most aggressive form of investing in bond funds. These funds can invest up to 10-35 per cent in equity, which helps them to reap better returns. However, they also carry the risk associated with investing in equities.

Don’t Time Interest Rate Movement

Many smart investors try to time the interest rate movement and take position accordingly. In a falling interest rate scenario they invest in funds with higher duration. During the rising interest rate they tend to invest in short duration bond funds that get benefited by the rising interest rate. Instead of timing the interest rate movement a simple way is to invest in a fund that matches your desired characteristics with the intention of holding it till maturity. This clearly protects you from adverse interest rate movement.

Match Your Fund to Your Risk Tolerance If volatility in your investment returns keep you awake whole nights, it is better to invest in shorter duration funds and be content with lower returns. Therefore, besides everything else, invest in only those debt funds that will help you to sleep soundly, which means of all the options available, invest in funds that fit with your risk profile.

Types of Debt Mutual Funds 

SEBI (Securities and Exchange Board of India) has classified debt funds into five main categories, viz. equity schemes, debt schemes, hybrid schemes, solution-oriented schemes and other schemes. Here is a description of the various types of debt funds and their time horizons: 

 Overnight Funds: Overnight funds have assets that are invested in overnight securities with maturity of just one day.
 Liquid Funds: Liquid fund assets are invested in debt and money market securities with maturity of up to 91 days.
 Ultra-Short Duration Funds: The ultra-short duration fund assets are invested in debt and money market instruments such that the Macaulay duration of the portfolio is between 3-6 months.
 Low Duration Funds: Low duration funds have assets that are invested in debt and money market instruments such that the Macaulay duration of the portfolio is between 6-12 months.
 Money Market Funds: These are funds wherein assets are invested in money market instruments having maturity up to one year.
 Short Duration Funds: Short duration fund assets are invested in debt and money market instruments such that the Macaulay duration of the portfolio is between 1-3 years.
 Medium Duration Funds: Medium duration fund assets are invested in debt and money market instruments such that the Macaulay duration of the portfolio is between 3-4 years.  Medium to Long Duration Funds: Medium to long duration assets are invested in debt and money market instruments such that the Macaulay duration of the portfolio is between 4-7 years.
 Long Duration Funds: Long duration fund assets are invested in debt and money market instruments such that the Macaulay duration of the portfolio is greater than seven years.  Dynamic Bond Funds: Dynamic bond funds are not restricted by investment duration. These funds are free to invest the assets across any duration.
 Corporate Bond Funds: A corporate bond fund is an open-ended debt scheme which invests at least 80 per cent of its total assets in highest-rated corporate bonds.
 Banking and PSU Funds: Banking and PSU funds invest minimum 80 per cent of the total assets in debt instruments of banks, public sector undertakings and public financial institutions.
 Gilt Funds: Gilt funds invest minimum 80 per cent of the total assets in G-Secs (government securities) across maturity.
 Gilt Funds with 10-Year Constant Duration: These funds invest minimum 80 per cent of the total assets in G-Secs (government securities) such that the Macaulay duration of the portfolio is equal to 10 years.
 Floater Funds: Floater funds invest minimum 65 per cent of the total assets in floating rate instruments.

In the above mentioned funds, you may have a query: what is the Macaulay duration? This is a concept developed by Frederick Macaulay in 1938. It measures the bond’s sensitivity to interest rate changes. Technically, it is the weighted average number of years the investor must hold a bond until the present value of the bond’s cash flows equals the amount paid for the bond.

Summing Up

The starting point of building any portfolio begins with clear objectives as to what is expected from the portfolio. With careful analysis of your personal and financial characteristics, an appropriate asset allocation plan is made for different categories of investments that can lead to the right portfolio. The next step is the choice of the individual investments and the extent of diversification among these investments. Finally, the management of the portfolio will be guided by your investment objectives. Managing a successful portfolio is more than selecting good investments.