Mutual Funds

Planning to invest in debt funds? Here’s a checklist

Deepak Jasani | Updated on September 13, 2020

Investing in debt funds is now being looked through an altogther different lens after many incidents — right from IL&FS default and a series of rating downgrades to the recent Franklin (Templeton) episode.

In the past two years, there have been a few regulatory updates in response to credit events and weak links in debt funds.

SEBI reviewed the risk-management framework of debt funds, set prudential norms for investments in debt and money markets, introduced segregation of portfolio for debt papers below investment grade, graded exit load in liquid funds, made valuation changes, placed sectoral limit and group-level exposure limits and so on.

Most (retail) investors in debt funds do not completely understand the risk and return dynamics of various sub-categories in this space. They are more passive towards managing and monitoring the performance of debt funds than with equity funds. Debt funds do offer a higher degree of capital safety; however, they, too, experience volatility due to interest and credit risks.

There are a few factors/checkpoints investors must consider before investing in any debt fund.

The first and the foremost criteria is matching the investor’s time horizon (liquidity needs) with the duration of the debt fund. For deciding on the time horizon, the investor should be clear of their financial goals. This important parameter is sometimes overlooked by investors, and they might stay invested in funds without understanding the risks involved.

SEBI has categorised debt funds into 16 categories for ease in decision-making. There are four broad categories — funds to meet temporary parking requirements (overnight and liquid), shorter-duration funds (three months to two years — ultra-short, low-duration, money market, floater funds, short-duration), medium- to longer-duration funds (including the two gilt fund categories), and other debt funds which includes banking and PSU, corporate, and dynamic and credit risk funds.

Each category has been given a boundary/framework within which it operates. Once you have a clear framework for asset allocation, sub-category-level distinction becomes clearer. If you are a conservative investor, stick to lower-duration funds that have a minimum duration and credit risk. Otherwise, one can chase the alpha bucket of debt funds, ie, duration and credit-risk funds.

Interest-rate sensitivity

By deciding on the investment horizon, investors decide on the interest-rate risk that is acceptable to them. The maturity profile of the fund makes investors understand the extent to which they are exposed to interest-rate risk. Higher the scheme’s duration, higher will be its sensitivity to interest rates.

A good measure to look at your fund’s sensitivity to interest rates is its Macaulay duration/average maturity which is readily available in the monthly factsheets published by the AMCs (asset anagement companies). Higher the modified duration, the more volatile your fund is, because the NAV impact on interest-rate changes will be high.

Another crucial aspect is the credit quality of the portfolio. Data on rating profile of a scheme is available in the factsheets, and highlights the extent of credit risk in the fund. In such uncertain times, investors are comfortable staying invested in funds which have high exposure to top-rated debt papers (AAA rated) and sovereign papers to minimise the credit risk.

One must also note that credit ratings are not cast in stone — in uncertain times, they might be subjected to downgrades, thereby impacting the NAVs. Again, credit risk is not bad, it attracts a few sets of investors who understand this landscape and are willing to take risk for the higher return that it brings.

Risk appetite

More importantly, your investments should be strictly in line with your risk appetite (both credit risk and interest-rate risk). Investors, at large, are not open to take risk or see negative returns in debt funds as they are meant as a store of value and invested primarily in to earn better returns than traditional debt instruments such as FDs.

However, debt fund NAVs now are more volatile than in the past.

Investors usually gauge their return expectations based on the yield-to-maturity (YTM) of the fund.

Higher the YTM, better it is for the debt funds. But investors should not get carried away and search for debt funds that offer higher YTM.

We are already aware of how things unravelled for such funds.

However, investor should not make the mistake of expecting the yields reflected by the fund YTM at the time of investment as there would be a lot of activity in terms of fresh entry, exits by varied investors, and fresh investments at varied yields between the time of their investment and their exit.

Apart from these check points, issuer-wise/group concentrations, sector concentrations need to be taken into account to ensure reasonable diversification; investment limits set by SEBI, however, cater to these to some extent.

Liquidity of the debt portfolio has also been also talked about recently, but it would be difficult for retail investors to comprehend the liquidity of the underlying papers.

After having invested in a debt fund, it is imperative that these key parameters — average maturity (Macaulay duration), credit profile, ratings by CRISIL, Morningstar and Value Research — are monitored on a regular basis to optimise the risk-return objective.

Long-term investors need to consider holding debt funds for at least three years given the tax benefit. Annual financial check-up/review of funds is needed to see if the interest-rate risk and credit risk carried by the fund and the volatility in its NAV still match the risk profile and the return expectations of the investor.

The writer is Head of Retail Research, HDFC Securities

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Published on September 13, 2020
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