June 7, 2018

16 Debt Fund Categories: Simplified ‘To Do’ for You

Joydeep Sen

WiseInvestor

16 Debt Fund Categories: Simplified ‘To Do’ for You

What should I do?

With so many fund categories around, and AMCs changing names or features of their funds to comply with the new norms, the question will come to you as to ‘what should I do’ or ‘which fund should I recommend to my customer?’ Let us make our life simple by focusing on only a few categories that are more relevant than others, particularly at this juncture of the interest rate cycle.

Current situation

As of today, the spread i.e. yield up-tick of Government Securities and Corporate Bonds over the overnight repo rate of 6%, which is the RBI signal rate, is much on the higher side against historical levels. This makes it inviting to enter bond funds, as the available yield levels are attractive. The higher the yield level, the higher is the level of accrual in the fund i.e. the rate at which the NAV goes up every day as interest on the securities in the portfolio becomes due.

On a relative basis, the shorter end of the yield curve, say up to 3 years maturity, will be more stable than the longer end, say 10 years maturity. This is due to the concept of duration – higher the duration, higher is the movement along with interest rates, hence higher the volatility.

Recommendation

At this juncture of the interest rate cycle, let us keep aside the idea of Long Duration Funds, where the duration (as distinct from maturity) of the fund has to be more than 7 years as per rule, hence it will always carry a higher interest rate risk i.e. volatility risk. Though yield levels are high and attractive, the debate now is when the RBI would hike rates and by how much, which would add to volatility. We can keep aside Dynamic Bond Funds as well – this category of funds has flexibility in duration management, but can be volatile as well.

What should you focus on? Short Duration Funds. Why? Yield levels are elevated, attractive to enter. 3-year maturity AAA-rated bond yields are at approx 8.5%, which is very sweet. The portfolio yield, also known as the running yield or ‘carry yield’ in fund managers’ parlance, indicates the accrual level in the portfolio. Market movements of interest rates or fund manager’s performance on portfolio duration management are expected to add to the returns of the fund, over and above the accrual level, over an adequate investment horizon. Short Duration Funds will be relatively less volatile than Long Duration or Dynamic Bond Funds, hence risk-adjusted or volatility-adjusted returns are expected to be handsome. In this context, last one year was an aberration. Last one year till date, Short Duration Funds have underperformed Liquid Funds as interest rates were rising and the impact of mark-to-market was adverse. Going forward, Short Duration Funds are expected to normalize i.e. outperform Liquid Funds.

Liquid Funds are evergreen parking products and need no elaboration. There are 3 categories defined by SEBI between Liquid and Short Duration Funds, which are Ultra Short Duration, Low Duration, and Money Market. These have been defined as per portfolio duration of 3 to 6 months, 6 to 12 months and up to 1 year respectively. The difference between these 3 categories would not be huge. For very short investment horizons, say few days, you should park in Liquid Funds. Short Duration Funds require a horizon of 6 months and longer; for horizons between Liquid and Short Duration, you can go for either of the 3 categories in between.

Food for thought

The other category you can look at is Credit Risk Funds. Though it is not mandatory as per SEBI’s new fund categories, in most of these funds, the fund manager keeps the portfolio duration similar to Short Duration Funds. The idea is, not to add much to the volatility risk because the fund is anyways carrying a credit risk. You benefit from the higher accrual level in Credit Risk Fund over a comparable portfolio maturity Short Duration Fund of a better portfolio credit quality. However, to be borne in mind, as the name suggests, there is a credit risk in this category. In the market, duration risk is discovered faster e.g. yield levels would move up if inflation is expected to move up in future, but if the fundamentals of a company is deteriorating, the market may be late in discovering it. So far, the mutual fund industry has managed the credit risk well, in the segment of credit risk-oriented funds.

Conclusion

Net-net, you do not require all the 16 categories of debt funds in your daily life. Be aware of them, as ‘on-the-shelf’ products. As of now, for your regular debt fund allocation, you can focus on the categories discussed above.