Download the latest issue of Business Today Magazine just for Rs.49

Playing It Safe

How to minimise interest rate, credit and liquidity risks in debt funds

Illustration by Raj Verma Illustration by Raj Verma

If liquid and short-term debt funds gave negative returns in March 2020 when the Franklin Templeton fiasco was on in full swing, duration funds turned negative in March 2021. Most debt schemes with long-duration investments, which had delivered double-digit returns in 2020, are back at single digits now. Experts blame volatility in bond yields for such a high variation in returns in the short term.

Debt funds are considered safe as they hold fixed-income securities. However, as the above examples show, this is not true. "Debt mutual funds are subject to mark-to-market valuation on a daily basis due to yield fluctuations which, many times, may lead to negative returns in the short term. However, this is a short-lived phenomenon as, over a longer period, you should generally earn what was the yield-to-maturity at the time of your investments unless there are some defaults in the underlying portfolio," says Raghvendra Nath, Managing Director, Ladderup Wealth Management.

Apart from these risks, the debt fund universe is complex, with as many as 16 categories. The performance of each category depends on the interest rate cycle. When interest rates rise, short-duration funds such as liquid and ultra-short-term funds do well, but long-duration funds turn risky. The opposite happens when rates are falling. Since interest rates were falling, duration funds such as gilt funds were giving double-digit returns in the first part of FY21. A different story will play out in FY22 as the yield curve rises.

"We see a very high chance of interest rates moving higher in the next one-two years. If that is the case, bond yields are likely to rise. The extent of increase or turbulence in the market will depend on the pace of normalisation," says Pankaj Pathak, Fund Manager, Fixed Income, Quantum Mutual Fund.

Post FY21, there has been a flight towards safety in debt funds. "We saw traction in traditional debt fund products such as AAA-rated corporate bonds and Banking & PSU bonds. Categories such as credit risk funds saw a dip in assets," says Kaustubh Belapurkar, Director, Manager Research, Morningstar Investment Adviser India.

Investment options

So, where should you invest now that the rate cycle is set to turn? Belapurkar says core investment should still remain short term and Corporate Bond Funds where you don't see credit risk. He vouches for recently launched target maturity and floater funds too.

A number of fund houses have launched new fund offers (NFOs) with a promise of low-to-negligible credit and interest rate risk. For example, Edelweiss has launched NIFTY PSU Bond Plus SDL Index Fund-2026, which invests in AAA-rated PSU bonds and State Development Loans in equal proportion. It is a target maturity fund, that is, a fund with a pre-defined maturity date. Then you have floater funds by DSP Mutual Fund, IDFC Mutual Fund and SBI Mutual Fund. A number of fund houses have launched Banking & PSU and Corporate Bond funds too.

"Over the last one year, returns were made through higher risk in duration. In layman terms - to earn return you were to marry risk. This year you need to embrace volatility and into the next year, you would need to divorce any form of risk in fixed income to earn returns. Going forward, for an investment horizon of one year and above, the short-term and credit segment is expected to do well compared to duration," says Saurabh Bhatia, Head, Fixed Income, DSP Mutual Fund.

Here are some categories you may consider at this stage:

Target Maturity Funds: Also called roll-down funds, these could be a substitute for fixed deposits. In FDs, you invest at a fixed interest rate, and after a period, get back your principal along with returns. The MF industry launched fixed-maturity plans as a substitute for FDs, but unlike FDs, premature withdrawals were not allowed, although returns were predictable. Target Maturity Funds, too, have an anchored maturity and so predictability of returns, but at the same time offer investors the freedom to sell whenever they want.

Since target maturity funds invest in government securities and PSU bonds, there is no credit risk. And as the maturity is pre-defined, too, they have negligible credit risk as well. "Only those seeking to avoid credit risk and having the same investment horizon as the target maturity of these funds should invest. Such investors should be comfortable with intermittent volatility in the bond yield curve till the scheme's maturity," says Sahil Arora, Director,

Floater Funds: These primarily buy floating rate securities. As rates offered by these securities are reset at regular intervals based on external benchmarks, they are less sensitive to changes in the interest rate regime. Hence, their interest rate risk is lower. "When yields go higher there are certain constituents in the floater funds, which can reset at a higher yield at a relatively lower cost. The regulatory mandate requires floating rate instruments to invest at least 65 per cent in floating rate instruments and hence in a rising rate scenario this can be helpful. In the falling rate scenario, there could be a change in tenors, which may benefit in the falling rate scenario as well," says Bhatia of DSP Mutual Fund.

"DSP Floater Fund is like a short-term debt fund that invests only in securities issued by Central and state governments, so there is no credit risk. People invest in short-term fund to earn accrual without worrying much about capital gains or capital losses. When interest rates are headed lower, the bonds give capital gains and your returns are amplified. When interest rates head higher there can be potential capital loss in the value of a bond and to mitigate the losses, the DSP Floater Fund bears exposures in overnight index swaps (OIS). Paid (sold) position in OIS works exactly opposite to the conventional bond. In paid (sold) OIS positions, you earn capital gains when interest rates go up. This aids to reduce extent of loss in your fund," he adds.

Banking & PSU and Corporate Bond Funds: These are evergreen options. Banking & PSU Funds invest in bonds and debentures of banks and public sector companies. The underlying portfolio usually has high credit quality and liquidity and low average maturity. Thus, it enjoys low interest rate and credit risk and is ideal for risk-averse investors looking for a substitute to FDs. It has the low risk profile of an ultra short-term debt fund and return potential of an income fund. AAA-rated Corporate Bond Funds also give you similar comfort.

How to Choose

Before you identify a debt fund, figure out your investment horizon. Then check categories that gel with your timeframe. "If your investment horizon is short term, that is, zero-three months, go with liquid funds. For anything between six months and three years, choose low duration, ultra short duration and arbitrage funds. For anything above three years, stick to short-duration funds because risk-adjusted returns in short-duration funds are much better compared with what other categories give," says Mrin Agarwal, Founder, Finsafe India.

Secondly, unlike equity MFs, do not go by past returns. "Normally people invest in a debt fund based on returns over last one year. It's the biggest mistake. For example, we got a lot of queries on gilt funds when they gave double-digit returns, but given the fact that we are looking at a rise in interest rates, its not a good idea to invest in gilt funds right now. So, avoid looking at historical data and get the category right as per your investment horizon," says Agarwal.

Thirdly, if a particular fund is claiming to offer a very high return compared with the rest of the funds in its category, you need to ask why. "Do hygiene checks by looking at the credit quality of the fund but the main thing is to ask how it is giving higher returns than the rest of the funds in its category," adds Agarwal.

Debt investment is tricky. You have to track the interest rate cycle and the constituents of the underlying portfolio. While fund houses have cleaned up their portfolios to a great extent post the Franklin episode, you should still do your homework. If you have chosen a product aligned with your investment horizon, a temporary blip in the yield curve shouldn't concern you.