InvestorQ : I am planning to invest in debt fund of mutual funds. Can you tell me some of the key parameters that I should be looking at to evaluate a debt fund?
Arti Chavan made post

I am planning to invest in debt fund of mutual funds. Can you tell me some of the key parameters that I should be looking at to evaluate a debt fund?

4 years ago

Remember, most debt funds aim to optimise returns on the fund with a mix of safety, yield and liquidity. Here are 4 things you as a debt fund investor must look for in the portfolio…

There are a plethora of factors to be considered when you invest in debt funds but here are a few very key parameters to be considered.

In the debt portfolio, what is the break-up of G-Secs and Corp bonds?

Sovereign debt, here, refers to the total exposure to central government debt. Since these are backed by the government guarantee they are virtually free of default risk. Hence the risk on such government bonds is quite low. The interest rate risk is still there in a government bonds but from a safety and stability perspective, the government bonds are always preferred. Then there is non-government debt which is essentially in the form of corporate and institutional debt. Apart from large Indian companies issuing debt, PSU banks and development institutions like IRFC, FCI, REC and PFC are constantly raising money in the market through bonds. While these blue chip bonds are not as safe as government bonds in terms of default risk, they are considered to be relatively risk-free considering their pedigree and strong balance sheets. As an investor you need to ensure that the portfolio mix of the Income Fund you are holding gives you an optimal mix of the safety of government bonds and the higher yields of private bonds.

If the fund is chasing yields in lower grades, is it really worth it?

This is something most fund managers do in the quest for higher yields. Normally, higher the credit rating of the bond, lower the yield. So government bonds give the lowest yield, large corporates and financial institutions pay a slightly higher yield while mid-cap companies and NBFCs will pay you still higher yields. The skill of a fund manager lies in bargaining for higher returns by moving down the rating curve without endangering the stability of the fund in question. Many a times quality companies with a strong pedigree tend to get a lower rating due to industry specific problems. That becomes an opportunity for fund managers to bargain for higher returns. However, as an investor you must ensure that the fund manager is not risking too much. For an Income Fund, an exposure of up to 15-20% on the higher side is admissible for AA rated stocks. The rest of the money will have to be in G-Sec debt and AAA rated debt.

How concentrated is the portfolio in one or few debt asset classes?

Most of us understanding concentration risk in equities, which is why investment gurus like Ben Graham have advised to diversify your risk in the markets. But what exactly is concentration risk in debt portfolios? Let us go back a couple of years to the case of JP Morgan Fund. A large exposure to the debt of Amtek Auto almost created a liquidity squeeze for the fund when the rating agencies downgraded Amtek Auto by several notches following a payment default. While SEBI has tightened exposure norms after that incident, concentrated exposure to a company or a promoter group continues to be a major risk for debt funds. There is also the risk of sectoral or thematic concentration risk in debt funds. For example, if your debt holdings are bonds issued by banks, auto and real estate companies then there is a thematic risk as all the 3 sectors are vulnerable to any upside in interest rates. All the 3 sectors are rate sensitive and any hawkishness from the central banks could raise question mark over the servicing of these bonds.

Not tenure of the bond but it is the duration that matters?

Duration is an interesting concept when it comes to debt funds. What exactly is the duration of the bond? When a company or the government issues a bond, while it will be redeemed at the end of the tenure, there are also intermediate interest payments either at intervals of 6 months or 12 months. Therefore, the actual principal will get paid back much earlier than the maturity of the bond if interest payments are also considered. In simple terms, this payback period is termed as the duration of the bond. We shall not go into the calculations of duration as it is too complex but suffice to say that higher the duration of the bond more is its vulnerability to changes in interest rates. A bond with duration of 7 years will be more vulnerable to rate changes than a bond with duration of 6 years. Therefore, you must prefer longer duration bonds when rates are likely to go down and shorter duration bonds when rates are likely to go up.