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Debt funds: Then and now

SEBI's fund classification system has resulted in the creation of 16 debt fund categories. We tell you what are they and how should you pick from them

Debt funds: Then and now

If you found debt funds a bewildering asset class to start with, SEBI's reclassification exercise has not made your life much simpler as it has now allowed 16 types of debt funds. But navigating this classification becomes easier once you recognise that SEBI has tried to distinguish funds on three key parameters - portfolio duration, the kind of debt securities held and credit risk taken.

On duration, SEBI has divided debt funds into nine buckets in place of the existing four. There's now a debt category for every maturity profile - from parking overnight money to investing in seven-year plus securities. The existing dynamic-bond fund category has also been retained.

Debt funds will now use the Macaulay duration, in place of average maturity, to measure their portfolio duration. That's not as complicated as it sounds. Macaulay duration is simply the weighted average number of years over which the bonds in the fund's portfolio will receive regular interest payments. The longer the duration, the more is the fund's vulnerability to interest-rate swings. Ideally, debt-fund investors must match their own holding period to the Macaulay duration of the fund they're buying to reduce the interest-rate risk.

But if you go by the kinds of bonds held, there are three SEBI-approved debt-fund types - corporate bond funds, gilt funds and banking/PSU funds. Based on the extent of credit risk taken (investments in bonds with lower credit ratings), again, there's a special category of credit-risk funds.

While the menu of debt funds on offer may seem befuddling, here are two easy routes for layman investors to deal with the new debt categories.

To park safe money, keep off duration
The performance of debt funds during the recent interest-rate cycle (2014 to 2018) has clearly shown that funds that pack their portfolios with long-term bonds generate big pay-offs when interest rates are falling but can also flop badly when rates begin to rise.

This suggests that debt-fund investors who are simply looking for a parking ground for their safe money should stick to debt funds which take on minimal rate risks by keeping their duration short. Under SEBI's new classification, liquid funds (securities up to 91 days), ultra-short-duration funds (Macaulay duration of three to six months), low-duration funds (Macaulay duration of six to 12 months) and money-market funds (duration up to one year) appear to be the best bets for such money. Even if rates happen to rise when you are holding these funds, the dent to your NAV will be capped because the bonds in the fund's portfolio will soon mature and be replaced with higher-coupon bonds. Unless you're a bond-market aficionado, it would be best to keep off medium-duration (three to four years), medium-to-long (four to seven years) and long-duration (over seven years) funds, which require an astute sense of timing.

SEBI has also allowed gilt funds and dynamic-bond funds as other debt-fund categories where fund managers can take active calls on rate moves. These are again a big no-no for lay investors who can't time their debt investments to peaks in the rate cycle. Given that dynamic-bond funds have basically mirrored gilt funds in calling rate cycles, there's not much value-add in owning them. Floater funds would be a good category for investors looking to mirror market movements in rates. But the lack of adequate floating-rate instruments in the Indian market makes this category largely irrelevant for now.

Earning a higher yield
One of the useful outcomes of the SEBI rejig is that it has drawn a bright line between corporate bond funds that take on credit risks and those that invest only in high-quality paper. Earlier, that line was quite blurred as 'accrual funds', 'income funds' and 'opportunities' funds could sit on quite a lot of lower-rated bonds unknown to the investor.

Therefore, if you are looking for a bank FD or corporate FD substitute among debt funds, corporate bond funds and banking and PSU funds offer good alternatives, where you make limited compromises on credit quality. While corporate bond funds are required to invest 80 per cent in highly rated corporate bonds, banking and PSU funds have to park 80 per cent of their assets in the stated sectors. Credit-risk funds, with a minimum 65 per cent exposure to bonds below the highest rating, can carry default risks. Use them mainly as a replacement for your direct investments, if any, in lower-rated corporate FDs or high-yield NCDs.

As before, a three-year holding period is essential to reap the maximum tax efficiencies from debt mutual funds. And systematic withdrawal plans are better vehicles to set up a regular 'income' from debt funds than the heavily taxed dividend options.

In short, you can build a hands-free debt portfolio just from three categories of debt funds - liquid funds (for emergency money), low-duration funds (for safe money without a maturity date) and corporate bond/PSU funds (for better returns than bank FD, along with tax efficiency).

Here's a list of all the debt fund categories.

Debt Schemes

Category Scheme Characteristics
Overnight Fund Investment in overnight securities having maturity of 1 day
Liquid Fund Investment in Debt and money market securities with maturity of upto 91 days only
Ultra Short Duration Fund Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 months - 6 months
Low Duration Fund Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 6 months- 12 months
Money Market Fund Investment in Money Market instruments having maturity upto 1 year
Short Duration Fund Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 1 year - 3 years
Medium Duration Fund Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 3 years - 4 years
Medium to Long Duration Fund Investment in Debt & Money Market instruments such that the Macaulay duration of the portfolio is between 4 - 7 years
Long Duration Fund Investment in Debt & Money Market Instruments such that the Macaulay duration of the portfolio is greater than 7 years
Dynamic Bond Investment across duration
Corporate Bond Fund Minimum investment in corporate bonds- 80% of total assets (only in highest rated instruments)
Credit Risk Fund Minimum investment in corporate bonds- 65% of total assets (investment in below highest rated instruments)
Banking and PSU Fund Minimum investment in Debt instruments of banks, Public Sector Undertakings, Public Financial Institutions- 80% of total assets
Gilt Fund Minimum investment in Gsecs- 80% of total assets (across maturity)
Gilt Fund with 10 year constant duration Minimum investment in Gsecs- 80% of total assets such that the Macaulay duration of the portfolio is equal to 10 years
Floater Fund Minimum investment in floating rate instruments- 65% of total assets