How to choose and invest in debt mutual funds

A challenge that many investors have always faced while evaluating different debt funds is the overlapping mandate/strategy between the various types of debt funds. There is even more confusion, at times, over significant unexpected and sudden change in the portfolio. Thus, lack of clarity has led to major gap between the investor expectation and performance of the funds on many occasions, leaving many investors disappointed and/or unsatisfied.

A major reform was instituted by the Securities and Exchange Board of India (Sebi) in this regard in October 2017, where the debt funds universe was divided under 16 broad categories, clearly defining the Macaulay Duration and the asset allocation range of each such category. The clear classification of funds will make it easier for investors to understand the debt funds.

Under new categories, debt funds are categorised over a two factor matrix, between duration and the credit risk.

Classification based on duration

Just as an example, under new rules, a long-duration fund should have a Macaulay duration of portfolio greater than seven years at all times, unlike in past where it was largely left to discretion of fund manager. Again, a short-duration fund must keep its Macaulay duration between one and three years at all times.

Classification based on credit risk

Similarly, on the credit risk side, there are two sub-categories: first is corporate bond funds, which should have minimum of 80% of investment in highest rated corporate bonds. Second is credit risk fund with minimum investment of 65% in corporate bonds, below the highest rating grade.

It is interesting that both credit based categories have no maturity based restrictions. With these clear articulated categorisations, it should be easier for investors to match their respective risk-return profile with that of the debt fund.

SIP works well in debt funds too

Majority of investors would ideally need some allocation to debt in their portfolio, in line with their risk-return profile. Investors generally shy away from volatile bond funds and stick to the safety of fixed deposits, as they find it difficult to accept the non-linear nature of bond fund returns.

Some analysts have even suggested that over the long run, over 10-30 years, bond indices have delivered similar, or in some cases even better returns than equity indices, both domestically and globally. Therefore, one should take extra efforts for proper allocation to appropriate sub-segments even within the debt component of the portfolio.

As mentioned earlier, the volatile nature of bond funds detract lots of investors from investing in them. Over the last few years, investors have begun to understand the merit of Systematic Investment Plans (SIPs) to not only withstand, but benefit from much higher volatility in equity markets. SIP has achieved a near cult status, as a tool for investing in equity funds. SIP is not specific to equity funds, but just a simple technique to average out investments in any volatile asset class.

Our forefathers have, for long, been doing SIP in gold by making fresh investments during every Dhanteras and so on. So the simple equation is – afraid of volatility in long-duration funds – do SIP in long duration funds. What about other funds like short duration funds etc? Higher the volatility, stronger should be the benefit of SIP. Long-duration funds theoretically have highest volatility of all debt funds. So, one should start with SIP in that component of the portfolio.

At conceptual level, whichever part of the debt portfolio one finds unacceptably volatile, SIP can come in to play. SIPs are the best way to gradually build a corpus by investing at regular intervals, while wrestling with market mood, be it equity or debt or any other asset class.

The writer is head, fixed income, Mirae Asset AMC