Are you a conservative investor? Do you have a two- to three-year investment horizon, and want to optimise your returns, keeping risks at bay? Then, in all likelihood, advisors, and our own recommendations in BusinessLine , would have directed you to invest a large portion of your debt fund portfolio in corporate bond funds, and banking and PSU debt funds.

The rationale? These funds carry relatively low credit risk and often low interest-rate risk, too. As a category, these funds have a good performance track record and have delivered 8-10 per cent returns across various time periods.

But as is the case with other debt fund categories, investors need to be aware of several caveats while investing in these funds, too. Of late, BusinessLine readers have been asking us if corporate bond, and banking and PSU debt funds are good options at this juncture.

Here, we look at the various contours of these two categories of debt schemes, possible risks in some of these funds and the broad factors at play in the bond market.

Factors at play

Debt mutual funds are exposed to interest-rate and credit risk.

Interest rates and bond prices have an inverse relationship. If the interest rates move up, bond prices fall (as investors flock to newer bonds that offer higher rates). Hence, if you want to minimise interest-rate risk, you should opt for funds that carry lower maturity (in their underlying portfolio), because shorter-tenure bonds are less sensitive to interest-rate movements.

Credit risk arises when a debt fund invests in low-credit-quality debt securities which may default on repayment. You can minimise your credit risk by picking schemes with a predominant exposure to high-quality debt papers (AAA rated).

Amid the pandemic-led crisis, the RBI has slashed interest rates by 115 bps this year. This has aided the performance of debt funds. But with the central bank hitting the pause button on rate cutsthere could be volatility going ahead.

So, conservative investors should stick with funds with lower maturity at this juncture.

Similarly, on the credit-risk front, massive disruptions across businesses have increased the possibility of a rise in downgrades and default in bonds in the coming months. Investors with a low risk appetite should stick with funds that carry high-rated bonds in their portfolios.

This is where corporate bond funds, and banking and PSU debt funds fit the bill.

Corporate bond funds are mandated to invest at least 80 per cent of their assets in highest-rated corporate debt papers. Most of the funds in the category maintain an average maturity of around three years, which also keeps rate risk under check.

Banking and PSU debt funds have to invest at least 80 per cent in debt instruments of banks, public sector undertakings and public financial institutions. This lowers credit risk (though certain risks may persist in a few funds, as discussed below).

They mostly carry an average maturity of about three years.

Hence, investing a large portion of your debt fund portfolio in these categories of schemes at this juncture can help deliver good returns, while minimising risks.

But while selecting funds, investors need to dig deeper into the portfolios.

Risks to note

SEBI’s categorisation norms do not specifically put a cap on the average maturity or duration.

So, while most funds carry an average maturity of 3-3.5 years, there may be some that carry higher maturity to add spunk to returns.

For instance, Invesco India Banking & PSU Debt Fund has an average maturity of 7.57 years as of July — this pegs up its interest-rate risk. However, the scheme invests 90 per cent of its portfolio in AAA rated bonds and the balance in cash, thus lowering credit risk.

Edelweiss Banking and PSU Debt Fund currently carries an average maturity of 8.86 years, which increases interest-rate risk, but the fund’s predominant investment in AAA and sovereign bonds lowers credit risk.

Similarly, in the corporate bond fund category, some funds carry a slightly higher maturity than others at over 4-4.5 years.

Hence, conservative investors who are not comfortable with taking interest-rate risks may need to check the funds’ average maturity before investing.

The other aspect that investors need to take note of is banking and PSU debt funds’ exposure to additional tier-I bonds (AT1 bonds) issued by banks. After the YES Bank crisis, when the RBI moved to write down the bank’s AT1 bonds fully, debt funds were hit hard. This was because funds holding these bonds had to mark down their value to zero.

Many of the banking and PSU debt funds currently have notable exposure to AT1 bonds of banks. Keeping a watch on the quantum of exposure to a particular bond and its rating will be helpful.

For instance, Kotak Banking and PSU Debt Fund has some exposure to AT1 bonds issued by a few PSU banks that are rated AA or AA-. HDFC Banking and PSU Debt Fund, too, has similar bonds.

While this does not imply that investors need to avoid such funds, reviewing such exposures is important. Remember, schemes that invest in AT1 bonds of sound banks are unlikely to run into trouble. In case of PSU banks, despite weak finances, the government backing — by way of capital infusion (if required) — offers some comfort.

However, avoid funds with high concentration of such instruments, particularly those issued by weak banks.