Debt mutual fund portfolio: How to construct a debt mutual fund portfolio (2024)

Arun Kumar of FundsIndia

After the recent troubles in some debt funds, it is critical that investors account for risks better and set the right return expectations.

ET Wealth shows you how to go about it.

DEBT FUND MANAGERS TAKE TWO MAJOR RISKS
1. Interest rate risk: Risk of decline in value owing to changes in interest rates. Rise in interest rates leads to a fall in value of traded bonds, hurting fund returns.

How fund managers take this risk
Depending on interest rate outlook, fund managers switch between higher or lower maturity bonds. They invest more in longer tenure bonds anticipating a falling rate scenario since these gain most in value

Represented by

Modified duration of fund portfolio

2. Credit risk: Risk of decline/loss owing to change in issuer’s credit profile, leading to downgrade or default

How fund managers take this risk
They invest in lower credit quality instruments that yield higher coupon rates. Potential upgrade in credit rating of the bonds can also fetch capital appreciation.

Represented by
Credit rating of underlying bonds

INVESTORS CAN TAKE A THREE-BUCKET APPROACH
Divide the debt fund allocation into three distinct buckets

A: Cash bucket
What for: To provide cover for immediate cash requirements or as emergency corpus
Focus on: Safety and liquidity take the highest priority in this category with returns being a residual of the first two factors
Where to invest: Overnight or liquid funds (Safest category with negligible interest rate or credit risk)
How much to invest: According to individual liquidity needs. Emergency corpus may be worth 3-6 months’ expenses

B: Core bucket
What for: This should form majority of debt allocation for conservative investors, who have moved from bank fixed deposits
Focus on: Slightly higher return profi le without compromising too much on safety
Where to invest: Low duration, short term, medium term, corporate bond, banking PSU categories (Funds low on interest rate risk and credit risk stick to high credit quality (80%-100% AAA & equivalent)
How much to invest: For conservative investors, recommend 100% in the core bucket (not including cash bucket). At least 50% for others

C: Alpha bucket
What for: For investors looking at enhancing returns, over and above the core bucket returns. Alpha bucket comes with higher risk but potential higher returns
Focus on: Maximising return by taking calculated risk in a small portion of fund portfolio
Where to invest: Dynamic bond funds, credit risk funds and debt oriented hybrid funds (refer to next illustration)
How much to invest: For portfolios with equity allocation greater than 50%, alpha bucket in debt can be avoided. For investors willing to take extra risk to improve returns, the sum of alpha bucket + equity allocation can be limited to 50% of the overall portfolio

ALPHA BUCKET CAN BE CREATED IN THREE WAYS
The multiple strategies investors can adopt:

A: Duration strategy
How it works: Actively managing interest rate risk to fetch higher returns. This happens through capital appreciation from a rise in bond prices
Where to invest: Dynamic bond funds
Watch out for: Success depends on the fund manager’s ability to time the interest rate cycle. Wrong calls can lead to losses
Max exposure: Up to 50% within alpha bucket

B: Credit strategy
How it works: Generating higher returns primarily through higher yield by investing in lower rated instruments while keeping interest rate risk minimal
Where to invest: Credit risk funds
Watch out for: Very poor credit quality of portfolio or concentration of holdings in low quality bonds can hurt if there are credit events
Max exposure: Limit to 30% within alpha bucket

C: Debt oriented hybrid fund
How it works: Mutual funds where partial exposure to equities in the range of 10-40% is taken to enhance returns
Where to invest: Equity savings fund, conservative hybrid fund
Watch out for: To counter volatility under equity portion, the debt portfolio should carry highest credit quality and low interest rate risk
Max exposure: Up to 50% within alpha bucket

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