Which debt fund category to choose for asset allocation?

Which category of debt funds is most suited for asset allocation between debt and equity? - S K Sharma

Asset allocation is still an important consideration when investing in financial securities. While equity provides superior returns to investors over longer time periods, it is subject to volatility. Debt, on the other hand, can provide some portfolio stability while yielding lower returns.

Relation between interest rates and returns
Investors should be aware that changes in interest rates affect the returns of debt funds. There is an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall, and bond prices go up when the interest rate regime is in a downward trajectory. The longer the duration of the debt fund, the more volatile they become in nature.

Which debt fund category to choose?
Within debt mutual funds, there are multiple options available in front of investors depending on their risk profile.

• If investors don't want to take any major interest rate risk or credit risk, they should allocate the debt portion towards liquid funds, ultra-short duration funds or low duration funds. All these funds invest in debt securities that mature between 91 days to one year.
• For asset allocation purposes, short duration funds should form the core of debt funds in the portfolio. Such funds have Macaulay duration of the portfolio between one to three years.
• If investors need the money within a year of the investments, they can go for liquid funds or low duration funds.

However, it is not advisable to invest in funds that are long-term in nature, like long duration funds or gilt funds. Such funds react quickly to the changes in the interest rates and are highly volatile.

Going the hybrid way
Investors can also look into hybrid funds as they are easy to understand and provide the advantage of automatic rebalancing of portfolios. Now, there are multiple hybrid funds available to the investors.

• Conservative hybrid funds allocate large investments in debt and not more than 25 per cent in equities.
• While in aggressive hybrid funds, investors get higher exposure to equity ( 65-80 per cent of the assets) and the remaining in debt.
• Lastly, there are dynamic asset allocation funds where fund managers take a decision on the markets and interest rates, and invest accordingly. When the valuations of the markets are expensive, the fund manager allocates a higher percentage of the portfolio to debt. If markets have corrected significantly and valuations have turned attractive, the fund loads on equity in the portfolio.

  In fact, asset allocation through hybrid funds can be done in a more tax-efficient way. This is because when a fund house sells the security to rebalance the portfolio, there is no capital gains tax. However, if the investor manually rebalances the portfolio, transactions will be applicable for capital gains tax.

Suggested read: How do I decide my asset allocation?