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  4. How to use each debt fund category in your portfolio

How to use each debt fund category in your portfolio

March 24, 2022

When it comes to choosing debt funds, you can get overwhelmed by the number of categories out there. Many of you wonder which categories of funds to choose for which time frame and need. SEBI doesn’t make it any easier, as there are sixteen SEBI defined categories under debt funds, and SEBI defines what each of those categories should hold or the kind of maturity the underlying instruments should have. 

As a result of having these many categories, many of you end up duplicating your portfolio inadvertently – believing that by spreading across different categories, you’re diversifying. However, funds that may be in different categories but not necessarily doing anything different for your portfolio. 

At PrimeInvestor, to both address this quirk and make it easy for you, we try to bucket our recommended funds – Prime Funds – based on your time frame of investing. For example, we bucket ultra-short, low duration, money market and some floater funds into a time frame bucket of 3 months to 1.5 years while short duration, most floater funds and banking and PSU funds may need a minimum of 1.5 years. 

In this article, we’ll explain these buckets and the differences in the characteristics of fund categories within these buckets.

duplication in debt funds

The buckets

Prime Funds use the following buckets to offer debt fund recommendations to you. This way, you need not worry about whether a certain fund/category will fit your portfolio. If you are wondering why we have not done the bucketing based on risk, we try to avoid risk as much as possible! 

A fund with high credit risk in say an ultra-short or short duration category would not find a place in our recommendation. If the risk is marginal, we explain it in the ‘Why This Fund’ section (and reason why you SHOULD go through it! 😊)

#1 Liquid

This category lets you park money temporarily and for emergency needs. Overnight funds, as you may be aware, are the least risky and have the shortest maturity. Liquid funds follow next. SEBI regulations ensure that these categories do not take any unnecessary credit risk and have very low duration. So, the distinction in terms of varied fund strategy is minimal within these 2 categories.

Choosing a fund with a large AUM (say at least Rs 1,000 crore) would help ensure that in the worst liquidity scenario, you redeem your money without any impact. 

The only learning here is that you should not compare this bucket with ultra-short or other lower duration categories as their risk profile and maturity profile are very different.

#2 Very short term

SEBI allows ultra-short duration funds to have Macaulay duration of 3-6 months. The same is 6-12 months for low duration and up to 1 year for money market funds. So, all of these funds suit the time frame of 3 months to 1.5 years that we fix for this bucket, and can be your own timeframe for these categories as well. 

Going by past trends, ultra-short funds have the least maturity, money market remains in the middle (although they can go up to a year) and low duration is higher. The table below captures the average maturity and Macaulay duration. For practical purposes, it is easier for you to follow the average maturity (the weighted residual maturity of the portfolio). Here you will find that low duration funds at present (and also typically) have higher maturity.

In terms of credit profile, money market funds, because they mostly hold certificates of deposits or commercial papers, do not sport a high-risk profile. You may have figured this from the marginally lower YTM they have. 

So, when you see funds with higher performance from any of these categories, it becomes important for you to know their risk profile. Funds such as ICICI Pru Ultra Short or HDFC Low Duration, for example, have traditionally held a relatively higher share than peers in papers below AA+. 

You don’t need to necessarily hold funds from each category in this space, unless you have a large investment and have the room for diversification. In short, you can look at these categories together for the purpose of choosing them. You need not worry much about the maturity profile. But make sure you know the credit risk profile - especially for funds in the low duration and ultra-short categories as our observation shows that it is funds in these categories that tend towards credit calls.

Our MF Review tool provides the buy/hold/sell recommendation with alerts on such risks for some debt funds where the credit risk is higher than warranted in the category. This way, you will be aware of the risk you are taking on. You can also use the MF Screener to look for different credit exposure.

#3 Short term

In this bucket we have 3 categories. Short duration, banking & PSU debt and floater funds. In this, banking & PSU funds can vary their average maturity but they largely stay in the 2–3-year maturity zone. Floater funds too have varying maturities. Some can be bucketed under very short term (above) while others can come under short term. 

In the table below, you might notice that the Macaulay duration (MD) of floater funds is far lower than their average maturity. Some of you have written to us about it. Since MD calculates the weighted average term to maturity of a bond's cash flows, in the case of floater instruments, the cash flow of only the next payment is known (since rates of underlying instruments keep changing). As a result, the date for the MD calculation is until the next cash flow only, and not till the maturity. 

Therefore, you will find a divergence in MD and average maturity. Technically, then, floater funds can come under the very short-term bucket (we do have some funds classified there). But given that they can be quite volatile, we bucketed them under short term.

Among these categories of funds, banking & PSU debt and floating rate largely have high quality credit given the nature of the instruments they hold. But banking & PSU debt can sometimes hold bank perpetual bonds – some of which may be risky, and where you may see holding in papers below AA+. However, the short duration category can hold some credit as SEBI defines only the maturity and not the credit quality or the type of the instruments they should hold. 

Another point to note in these two categories is their YTM. In the short duration category, the YTM may be representative of what you broadly earn as accrual. In the banking & PSU debt space, actual returns can be more influenced by capital gain appreciation or loss. So, comparing only the YTMs here can be deceptive, especially in a falling rate scenario. 

In floater, too, rates can reset faster than others and hence, YTM may not provide a clear idea. In this category, you can use our MF Screener to look at performance parameters and risk parameters and choose funds, if you wish to look outside of Prime Funds. 

To sum up, within this bucket, the floater and banking & PSU debt high quality low credit risk while short duration may provide higher accrual with marginally higher risks.

#4 Medium term

This bucket too largely provides accrual-based funds – corporate bond and medium duration. In medium duration, SEBI requires an MD of 3-4 years. But it does not state the credit profile for the medium duration category. On the other hand, for the corporate bond category SEBI clearly mandates holding high quality papers (read the SEBI link given in the beginning of this article), but does not define maturity here. 

However, both have maturities in the range of 3-4 years on an average. This makes them a little more volatile than the short duration space - but then they also provide more ‘duration-driven gains or losses’. That is, they are sensitive to rate movements as their maturities are higher. They can hold a range of instruments from certificates of deposits to bonds and debentures to even gilts.

On the risk front, since corporate bond funds’ credit holding is defined clearly by SEBI, there is no ambiguity and they remain high on credit quality. However, medium duration funds are a motley set when it comes to credit risk. While medium term funds like HDFC Medium Term Debt or Axis Strategic Debt hold even up to a third or more in papers less than AA+, others such as IDFC Bond – Medium Term hold none. So, this category has to be carefully navigated even though their maturity profile might seem similar to corporate bonds. 

If you are not doing your own research, it is best to stick to corporate bond funds than look at the medium duration category.

#5 Long Term

As given in the first table, all funds that have a longer maturity or can dynamically change their maturity come under this category. As a majority of instruments in the market with longer maturity are gilt instruments (barring perpetual bonds or few long-term corporate bonds), most of these funds (barring dynamic bond which can hold any instrument of any maturity) hold gilt or SDLs. They are highly interest rate sensitive and can show volatile returns. 

Among these, dynamic bond funds, long and medium-to-long funds can sport credit risk while gilt and constant maturity are free of credit risk. We are not providing their average maturity here as it varies widely even within categories (depending on the fund manager’s call on interest rate) and may not represent the category correctly. 

We believe the above categories are ideal to play duration. And in our view, when you take duration, it is better to avoid credit risk. Hence, this bucket is best played with gilt or constant maturity funds. It is fine to skip the rest. 

We have also categorized credit risk funds here. This, even though they sport an average maturity and MD between 2-3 years. The reason is because this category of funds is high risk and will need a longer time period of holding if they take any NAV hits due to downgrades or defaults. It is important that you do not compare credit risk funds with funds of similar maturity in the short duration or corporate bond space as credit risk funds have a far higher credit risk profile. 

Simply put, this long-term bucket houses all interest rate sensitive funds as well as those that need a higher period holding (dynamic bond and credit risk) because they are volatile or hold higher credit risk. Depending on rate cycles, we may sometimes classify some of the dynamic bond funds under medium duration as well. But as an investor, if you are doing your own research, it is best that you look at these categories from a 5-year plus perspective. 

The next time you use MF screener, try downloading your data by bucketing funds as discussed above for narrowing your choices better. This article on how to use the different debt fund categories may also be useful – it explains the categories most suited given your timeframe.

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