This article on the best debt fund categories for your portfolio, was originally published in July 2020. We are now republishing this for the benefit of our newer subscribers.
Which are the best debt fund categories for your portfolio? This question is best answered based on time frame. Unlike equity, where the time frame has to be long term and only your risk appetite will matter, with debt, your time frame is paramount to choosing the right debt fund. (read our earlier article on choosing equity fund categories here).
In this article we will discuss about the various both debt fund categories and how to choose them. This article is for beginners and those who are recent entrants in mutual funds. You can skip if you are a pro!
Debt fund categories
As with equity funds, in debt funds too, you don’t need to follow SEBI categories exactly. As always, go by what the fund does and what you need from your investment to decide which category to have in your portfolio.
In debt funds, three rules to keep in mind when looking at funds:
- There are many overlaps between fund categories. For example, portfolios of ultra-short duration, low duration, and money market funds are very similar in their risk and maturity make up. This means that you need to look at more than one category for your need.
- Outside of corporate bond and credit risk categories, no other category specifically defines what the credit quality of the portfolio should be. Therefore, always look for credit risk in your fund choice, especially when your timeframe is less than 3 years.
- Go by timeframe when deciding what type of debt fund to have. Both the category’s definition and the portfolio’s average maturity will give you an idea of the timeframe needed. Don’t use categories meant for a longer-term holding for a shorter timeframe. But it is perfectly fine to use short-term categories for long-term timeframes.
To make it easier to understand the similarities and uses of debt fund categories, we’re going by timeframe. You will see a similar classification in debt recommendations in Prime Funds.
Best debt fund categories by time frame
Timeframe – less than 6 months
Best debt fund categories to use – liquid, overnight
For such extremely short timeframes, your aim is not to earn high returns. It is safety of capital first. On this count, liquid and overnight fund categories work the best no matter what your risk profile is. Both categories will help generate returns more than your savings bank account. If you are absolutely risk-averse, or have a timeframe of just a few weeks, go for overnight funds. Else, either of the categories, or a combination of the two will work. If your investment amount is large, spread it across 2-3 funds to avoid concentration risk.
Sometimes, you may not have a clear purpose for the amount you want to park here, or you may not be certain you will need to access it. In these cases, what you can do is to pick the equity funds that you may eventually want to invest in and invest in that same AMC’s liquid fund. This way, should you not require the money, you will easily be able to set up an STP or smoothly switch into the equity fund. Liquid funds also are suitable for SWPs to generate steady cash flow. They can also be used for emergency portfolios.
It is safety of capital first. On this count, liquid and overnight fund categories work the best no matter what your risk profile is.
Timeframe – 6 months to 1 year
Best debt fund categories to use: Liquid, ultra-short duration, low duration, money market, floating rate
Money market funds invest in certificate of deposits, commercial papers, and treasury bills. Funds in the other categories given above for this timeframe also tend to invest in the same instruments – they just would also include bonds with a short residual maturity, or interest rate derivatives/swaps. All categories have average maturities of around 1 year or below and therefore suit very short-term requirements.
But because these funds see a bit of volatility on a weekly basis and may also slide into marginal losses on a 1-month basis, keeping a minimum 6 month timeframe is needed to even out such volatility. Liquid funds, of course, will not be volatile, but we have given it as an option here for the more risk-averse investors. You may use a blend of liquid funds and other categories as well, especially if your horizon is more towards 6 months.
Again, with such a timeframe, safety comes first. And therefore, though you may be willing to take risk, avoid doing so. On the same count, avoid funds where there is exposure to papers of low credit quality. The Prime Funds recommendations in this bucket are a mix of the categories above and are low on risk.
These funds can be used along with liquid funds to build an emergency portfolio. Refer to our emergency portfolio for such a combination or use it as a guide.
Since these funds see a bit of volatility on a weekly basis and may also slide into marginal losses on a 1-month basis, keeping a minimum 6 month timeframe is needed to even out such volatility.
Timeframe: 1 year to 3 years
Best debt fund categories to use: Short Duration, Banking & PSU Debt, Ultra-short, Low Duration, Money Market, Floating Rate
This timeframe is when you can start looking at better returns plus safety instead of only safety. Short-duration and banking & PSU funds will provide you with the higher returns for this timeframe. In a falling rate cycle, banking & PSU funds can especially work well as they stand to gain from price rallies in PSU bonds.
The categories given here can be used by investors across risk profiles. Use a combination of these categories depending on your timeframe, risk and investment amount, or go for any category alone.
For instance, if you are a conservative investor with a timeframe tending more towards 1 year, you can make higher allocations to money market/low duration/ ultra-short funds and smaller to short-duration and banking & PSU funds. But if you have a longer timeframe or are higher risk, you may choose to completely invest only in short duration/ banking & PSU funds. Such investors may even wish to combine these debt funds with low-risk hybrid funds (explained below).
Do note that while return does take some importance here, don’t fall into the high-yield trap. Avoid funds with more than 15% exposure to papers rated below AA+. The timeframe does not give you enough freedom to pull through any adverse events.
Short-duration and banking & PSU funds will provide you with the higher returns for this timeframe. In a falling rate cycle, banking & PSU funds can especially work well as they stand to gain from price rallies in PSU bonds.
Timeframe: 3-5 years
Best debt fund categories to use: Short Duration, Banking & PSU Debt, Corporate Bond, Medium Duration (ensure no or low credit risk)
Of the categories given here, only medium duration funds have a definite average maturity that falls into this timeframe. But as we said at the start, you can use a shorter-maturity fund for a longer-maturity period; this is the reason for including the range of categories given above. Such funds are low volatile, tend to be safer, and you may not always gain by going for long-maturity funds. So for conservative or even moderate risk investors, using short-duration/ banking & PSU funds may be far more suitable than going for medium duration funds.
Corporate bond funds, of course, score on portfolio quality. You may find corporate bond funds with portfolio maturity of 1-2 years. But the reason we’d prefer using them only for longer timeframes is because maturities can change. Going for these funds when your timeframe is short may suddenly leave you with a fund that’s unsuitable, though high-quality.
As always, you can use any of these categories on their own or use a combination depending on your risk profile. And again, avoid funds with high exposure to papers rated below AA+. If you’re using debt funds along with equity funds for a medium-term goal, then the equity allocation on its own will have higher volatility and risk; adding risk on the debt side, therefore, can be avoided. If you do want to take the risk for the higher yield, ensure that low-credit exposure is not above 20-25% of the portfolio and that such funds are not the entire debt allocation.
You can use a shorter-maturity fund for a longer-maturity period; this is the reason for including a wide range of categories, so every risk profile has different category options.
Timeframe: 5 years & longer
Best debt fund categories to use:
- For all risk profiles – Gilt with constant maturity, gilt, corporate bond, medium duration, short duration, banking & PSU.
Gilt funds (including constant maturity) are ideal fits for debt allocation of long-term portfolios where you simply need debt to balance equity risk. These funds will be volatile on a month-to-month or even on 1-2 year timeframes – on an average, gilt funds delivered losses about 4% of the time on a 1-year rolling basis over the past 8-9 years and less than 5% return a fifth of the time. But they eventually even out over periods of 5-7 years and longer. Their nil credit risk make them good fits for any investor.
Else, mix categories depending on your requirement; if you wish to keep volatility low, consider short duration/ banking & PSU funds. If you are not a high-risk investor, ensure that the funds you want to include (especially medium duration funds) are free of credit risk.
- For moderate to high-risk profiles – dynamic bond, or medium duration funds that take credit calls
Like gilt, dynamic bond funds can be volatile. But unlike gilt, these funds are higher risk as they change strategies depending on the rate cycle. Missteps here can cause returns to remain subdued; when these funds shift to accrual during rising rate cycles from duration, there can be an element of credit risk as well. Therefore, they need a relatively higher risk appetite. If you’re going for dynamic bond funds, avoid keeping it as your only debt exposure. Pair it with high-quality accrual funds, and not with gilt funds.
If you’re using higher-risk medium duration funds, again, follow the same allocation rules as given for dynamic bond funds. Moderate-risk investors can look at funds where credit allocation is less than 35% of the portfolio.
Note that you don’t need to have this segment for 5-year plus time frames. All we’re saying is – if you decide to have these categories, you necessarily need to have a moderate-to-high risk profile.
- For very high risk profile – credit risk. Other than the credit risk category, you can again go for funds from other categories where credit risk is high. If you wish to go for such funds, be prepared to weather credit events. Don’t earmark these funds for important goals that cannot be adjusted – such as children’s education. Keep allocation low and ensure that you also have high-quality accrual funds in your portfolio.
Here again, credit risk need not be part of any portfolio. If you go for it, you necessarily need to have a high risk appetite.
Mix categories depending on your requirement; if you wish to keep volatility low, consider short duration/ banking & PSU funds. If you are not a high-risk investor, ensure that the funds you want to include (especially medium duration funds) are free of credit risk.
To know about tax impact on debt funds read this article.
