Building a debt fund portfolio

Rajeev Radhakrishnan
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Debt mutual funds such as money market funds and fixed maturity plans have been a very popular investment avenue for retail investors over the last couple of years.

The RBI policy stance and tight systemic liquidity led to money market rates remaining elevated over this period. This provided scope for higher accrual of interest income in money market products and passively managed FMPs.

Change in scenario

Moderation in economic growth, tight liquidity and softening in inflation from elevated levels has resulted in the RBI changing the monetary stance recently, starting with the CRR reduction of 125 bps during January-March 2012 and 50 bps repo cut in April 2012.

Subsequent to the policy actions and the RBI’s open market purchase of securities, the liquidity situation in the market has normalised substantially. But this has resulted in moderation in money market rates. Going forward, an improvement in liquidity could keep short-term rates lower.

The relatively elevated headline inflation numbers and the fiscal situation may constrain aggressive policy rate reductions in the near term.

Over a slightly longer-term horizon of a year, it is anticipated that slowing economic growth could lead to further moderation in core inflationary pressures. This, coupled with the global economic backdrop, could provide scope for policy rates in India to move lower from the current levels. In the current interest rate scenario, which is characterised by easing of liquidity pressures and near-term uncertainty on the rate cycle, retail investors can still optimise their overall portfolio via investment in debt funds such as ultra-short schemes, short-term income funds and dynamic/long-term income schemes.

The selection among these categories and the allocation should be dependent on the three key variables of an investor — investment objectives, risk appetite and investment time horizon.

Ultra short schemes

Ultra short-term schemes are debt funds where the majority of investments are made in instruments with a three-month maturity but with the flexibility to take exposure to securities beyond this tenure.

This enables the portfolio to generate slightly higher yields as well as take active views on the money market rates. The returns from these funds are a function of the prevailing money market scenario.

Investors in these funds are exposed to lower interest rate risk. The credit risk in these funds is also addressed by investing in securities with the highest credit ratings.

The dividend distribution tax (DDT) applicable for retail investors in these funds is 25 per cent (plus applicable surcharge and cess) in liquid schemes whereas ultra short term funds which are in the category of income funds attract a DDT of 12.5 per cent (plus applicable surcharge and cess).

These schemes are ideal for investors with a very short-term horizon, a limited risk appetite and who desire a stable accrual income.

Ultra short-term funds are suitable for an investment horizon ranging from a week to a month. They can be considered as an alternate investment avenue for retail individuals to park their short-term surpluses in a tax efficient manner.

Short-term funds

In the prevailing scenario, retail investors could also look at a combination of products to exploit the current interest rate cycle and to generate optimal risk-adjusted returns.

For retail investors with moderate risk appetite and wanting liquidity, short-term funds are a good option for investments with tenure of at least six months.  Short-term income funds generate returns through a combination of interest income that accrues and capital gains on the invested portfolio.

Spreads in the AAA segment in the one- to three-year corporate curve currently remain attractive and therefore provide scope for high interest income accrual.This segment is also likely to benefit from the easing of liquidity pressures. Short-term income funds have an investment mandate to exploit the above opportunities.

They have the potential to also generate capital gains when the market yields move down, as the spread compresses.

These schemes typically maintain a portfolio average maturity of around two-three years. Hence they are exposed to relatively lesser interest rate risk in comparison with long-term bond funds and would appeal to investors even in the current interest rate cycle.

Long-term funds

Long-term income and dynamic bond funds carry higher interest rate risks and are suitable for investors with a horizon of at least a year.

Long-term income funds seek to maintain a core investment in medium-to-long-term corporate bonds. The higher allocation to corporate bonds ensures that the portfolio accrual (interest income) remains high.

They are also well-positioned to capture the gains from any downward movements in yields. These funds normally invest in a portfolio comprising corporate bonds, Government securities and a marginal allocation to money market securities largely to meet ongoing liquidity needs.

Dynamic bond funds have a more flexible asset allocation within the debt segment with the portfolio focused to capture tactical opportunities aggressively.

These funds are likely to have a higher portfolio churn compared with income funds. Dynamic bond funds have outperformed during time of market volatility as in the previous year as opportunities have arisen across both money market as well as Government bond space. But both long-term income and dynamic bond funds carry higher interest rate risks and are also prone to high volatility compared with short-term income and ultra short-term funds. Investments in these products would be suitable only for investors with a higher risk appetite.

Investment objective, risk appetite and time horizon will decide your fund choice.

(This article was published in the Business Line print edition dated September 2, 2012)
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