Debt Mutual Funds – How to Construct a Debt Funds Portfolio?

Asset allocation plays a significant role in portfolio management for any investor looking to diversify their risk. It is difficult for an investor to predict the direction of an asset class at any given point of time, making it important to have a well-balanced portfolio comprising of different asset classes to earn higher risk adjusted returns. The objective of asset allocation is to diversify the portfolio while minimizing overall portfolio volatility and maximizing overall returns.

Debt Mutual Funds should be an important part of an investor’s overall asset allocation. They are a category of mutual funds that invest primarily in fixed income instruments (such as bonds) issued by government, public and private companies. By investing primarily in these instruments, debt mutual funds are able to generate returns which are comparatively low risk while at the same time offer capital protection. Debt mutual funds are also less volatile compared to their equity counterpart and offer relatively more stable returns.

While equity funds help to grow the portfolio by generating wealth at high returns, debt funds help to mitigate any risk posed by the high-risk nature of the equity funds.  Every good portfolio must have adequate exposure to debt funds. Before we talk about how to choose the right debt funds, let us first understand the different types of debt funds. These arebased on the instruments they invest in, the credit quality and the tenure of the instruments.

Types of debt funds

Debt mutual funds belong to various categories as given below:

• Liquid funds: Perhaps one of the more convenient funds in this category, these funds provide for instant 24-hr redemption. Liquid funds can be used to park short-term cash and you can instantly redeem uptoRs 50,000 at a time. One way to invest in these schemes is to park your entire salary or at least a large portion of it in liquid funds and use it for regular expenditure. These funds work best when the investment amount is large. The risk involved in these schemes is also very low as the maturity period is low (usually 1 day-3 months). Please do note that as per recent SEBI regulations, these funds are subject to exit load if redemptions are done within seven days of the investment.

• Money Market Funds: These funds invest in money market securities which have a maturity of upto 1 year.Money market securities consist of highly-liquid, short-term instruments such as Treasury Bills, commercial papers, certificates of deposits, CBLO, among others.

• Ultra Low Duration Funds: These are funds that invest in papers with a duration of 3-6 months. These are slightly riskier than liquid funds but are still relatively a low risk category of funds. These funds can be considered by those investors who are looking for liquidity within three to six months of investment. These funds have low interest rate risk.

• Low Duration Funds: This category of funds invests in papers with a duration of 6-12 months range. These funds are suitable for those who want to invest for a period of 6 months to one year. These funds also are not very sensitive to interest rates.

• Short Duration Funds: These funds invest in papers which have a duration of between one and three years. They are interest rate sensitive as they invest in papers with a slightly longer duration than the ones mentioned above. So investors with a higher investment horizon could consider these funds.

• Medium Duration Funds:These funds invest in debt securities and money market instruments so that the Macaulay Duration of the fund is between three and four years.These schemes are more susceptible to interest rate movement and riskier than short duration funds.

• Long Duration Funds:This category of fund invests in fixed-income generating securities such as government securities, corporate bonds, commercial papers, treasury bills, etc. with average maturity of more than 36 months.

• Credit Risk Funds:Creditrisk funds are a type of debt funds that invest approx. 65% of the investment corpus in AA-rated papers and below. By investing in lower-rated securities, these fundsproduce high returns but come with a substantial amount of risk. It is important to understand and know what papers these funds invest in before taking an investment decision. These funds are suitable for those investors who are willing to take some amount of risk.

Debt mutual fund schemes are subject toshort -term and long-term capital gains tax. Short-term capital gains tax is applicable when the holding is for a period 36 months or less. The gains are taxed as per the applicable income tax slab of the investor. Long-term capital gainstax is applicable on holdings which are for more than 36 months. Long-term capital gains on debt mutual funds are taxed at 20% with the benefit of indexation. Indexation is a method of factoring inflation from the time of purchase to sale of units. Indexation benefits reduce the tax obligation of an investor considerably as it increases the cost of acquisition thereby reducing the overall gains made by the investor.

When choosing debt mutual funds investors must consider the goal for which they are investing and their risk appetite. For more short-term or medium-term goals, investors should consider those debt mutual funds that are less sensitive to interest-rate movement with limited risk. This is because in the short-term or medium-term debt funds are not that sensitive to interest rate movements. The investor’s aim is to generate income that can be used to satisfy more immediate financial goals or needs. For the longer term, investors could consider funds with a longer maturity but good credit profile as in the long-term debt funds become extremely sensitive to interest rate movements.

Periodic rebalancing of asset classes is important and also helps investors to protect downside by booking profits in relatively outperforming asset classes and increasing exposure to relatively underperforming asset classes.By investing in a combination of asset classes, an investor ensures that any negative returns from one asset class (in this case equity) is cushioned by the other (debt), thereby causing less damage to the overall portfolio return.