One of the advantages of investing in debt mutual funds as against other fixed income instruments is that investors get the benefit of lower tax rates and get market returns as opposed to fixed deposits. If held for longer than three years, then long-term capital gain (LTCG) tax is applicable.
And as far as returns are concerned, they are not only from the accrual of interest income for the bonds in the portfolio, but also due to capital appreciation. One must remember that bonds earn interest income which accrues, and bond prices appreciate when interest rates fall, and bond prices drop when interest rates go up. The returns to your bond fund portfolio are a combination of interest accrual and bond price movement.
As with any investment, there are three factors to keep in mind: liquidity, safety and returns. And since fixed income is to form the stable part of your overall portfolio, you need to ensure that you get this right.
To help investors construct a smart debt portfolio, financial coach MAHESH MIRPURI suggests that it be broken up into three components. He explains in detail below.
- Component 1: Emergency Fund
- Why do you need this? In a crisis you shouldn’t have to worry about financial stress that will cause you to borrow or sell your current investments
- Chief Pursuit: Safety and Liquidity
An emergency, by its intrinsic nature, is meant to urgently cater to the unexpected. Which means, you will need to access the money instantly should the need arise. Hence, keep a laser focus on liquidity and safety.
How much you need to invest here is a very personal issue, but I would suggest a minimum of 9 months of household expenses. This amount can be place in either one instrument, or a mix of two or three.
A bank fixed deposit is one option.
If you want to consider mutual funds, go for liquid and ultra short-term funds.
Liquid funds primarily invest in money market instruments - commercial paper (CP), treasury bill (T-bill) and certificate of deposit (CD) with low maturity periods.
Ultra short-term funds primarily invest in liquid fixed income securities which have short-term maturities.
- Component 2: Core Portfolio
- Why do you need this? For asset allocation and stability in a portfolio
- Chief Pursuit: Safety, with an eye on post-tax returns
This will form the bulk of your fixed income portfolio. It is what must be considered when you look at your overall portfolio allocation. An optimal portfolio will be multi-layered.
One of the avenues are the assured return investments such as fixed deposits, Public Provident Fund (PPF) which has a limit, RBI bonds, and small savings schemes.
Another avenue which is increasingly popular is debt mutual funds that are low on duration risk and credit risk.
To simplify, there are two types of risk:
Duration risk refers to the risk caused by bond price movements. If you take funds that are susceptible to volatile movements, this may hurt if you need to withdraw funds or re-allocate. To avoid this, stick to shorter term bond funds.
Credit risk refers to the risk of a loss when a borrower does not pay back. This amount is not easily recovered and should be avoided. The risk of default is worse than duration risk. To avoid this, stick to funds that invest in Banking and PSU Bonds or high quality corporate bonds.
In brief, the funds one can look at to make the core part of the portfolio are funds which hold shorter term paper with maturities up to 3 years, which invest in high quality papers like government bonds, PSU and bank bonds, highest quality corporate bonds. A category which is popular now are the Target Maturity Funds which invest in high quality PSU, government bonds with maturity as on a certain date. Such funds are closed on that date and the funds returned. The reason for investing in such funds is that the approximate return expected is known at the time of investment – if one holds on till maturity (closure of the fund). These can be volatile in the interim.
Here are some questions to answer that will guide you in your fund selection.
* What is the quality of the portfolio. If you are unable to fathom that, please invest through a distributor or an advisor. You should not get a loss due to default. Core portfolio should not carry credit risk.
* What is the weighted average maturity of the bonds in the portfolio? This will give you an indication of duration risk.
* Is it a purely open-ended fund or a “target maturity” fund. You can invest in the latter but be aware that the duration is set and in the interim it can be volatile.
* What does your research on the Liquidity of the portfolio reveal? Your open-ended debt fund must be able to provide for liquidity in the assets that it holds. This means that when faced with redemptions it should have assets that can be liquidated and with reasonable impact costs. When selling assets, the risk profile of the remaining assets should not shoot up or be concentrated, like we have seen in the credit crisis that happened some years ago.
- Component 3: Tactical Portfolio
- Why do you need this? You don’t, but it does give an option to dabble in certain funds for extra returns if you have a fairly large debt portfolio
- Chief Pursuit: Returns, with an eye on safety
This is where you can afford to be a bit adventurous in the hunt for returns. To take advantage of market conditions, 15-20% of your debt allocation can be channelised into this bucket. Having said that, this bucket demands a much deeper understanding of the investing mandate of the types of debt instruments / funds and their corresponding risks.
Gilt funds would fit here. These funds have no credit risk or risk of default. Their risk is interest rate movements. If you expect interest rates to dip in the future, you could consider a tactical investment here.
For many individuals, credit risk funds too would fall in this satellite category. However, I would advise tremendous caution because there is a risk of default and wiping out capital permanently.
Hence, I reiterate that a much more nuanced expertise is required when allocating money to tactical bets. The risk of a credit fund is totally different from that of a gilt fund. Gilt funds, on the other hand, are not a homogenous lot. The category has actively managed gilt funds of different durations and constant maturity gilt funds.
Dynamic bond funds would fall under this category. Dynamic bond funds have the investment mandate to invest across durations and even take credit risks. They have no restriction on duration or credit quality. Consider them after ONLY getting well acquainted with the fund manager’s strategy. Steer clear of funds with credit risk.
Non-convertible debentures (NCD) issued by companies also fall into this category. Again, the risk here cannot be ignored. Study the company and check the rating of the instrument before investing.
My final word of advice: If you are not able to handle this, take professional help.
Mahesh Mirpuri is a financial coach, mutual fund distributor and a passionate advocate of asset allocation. You can follow him on Twitter.
