How To Identify A Right Debt Fund Strategy Matching Your Requirements

Investing in debt funds require little more effort. Once an investor has identified her goals and period of investment, she has to choose a fund from a particular category. Funds in the same category could be running different strategies. In this article, we discuss different types of portfolio strategies deployed in the debt funds and how to choose a perfect strategy for you.

Let’s begin with some key parameters:

Average Maturity

Debt funds invest in securities with variable maturity period. Average maturity of a debt fund is the average of maturities of all the securities in the portfolio. Average maturity would indicate if the fund follows a long-term strategy or the short-term strategy.

Modified Duration (MOD)

Modified Duration indicates the sensitivity of the fund towards interest rate changes in the economy. Funds with higher MOD will have sharp reaction to the interest rate changes.

Yield to Maturity

The yield or the return on the instrument, if held till its maturity, is known as the Yield-to-maturity (YTM). YTM of a fund is weighted average yield of all the securities/bonds present in that fund. This parameter gives an estimate about how much return can be delivered by a fund for a year.

Investment in debt funds can generate money either through capital appreciation that is buying and selling of securities very much similar to equity shares or through interest payout or through a combination of both. Let’s take a look at them:

Duration Based Strategy

When a fund manager uses duration strategy, he/she takes a call on the direction of interest rate movements and accordingly focuses on adjusting the duration of his portfolio to maximise returns. He is less focussed on searching for corporate bonds with higher coupon rates – he rather prefers to cut out the entire credit risk aspect, stick to government bonds, but focuses on managing duration to drive returns.

The funds which follow the Duration based strategy invest in long term bonds and benefit from the fall in interest rates. They earn from capital appreciation along with the coupon of the bond. These funds are exposed to interest rate risk and if the interest rates move up these funds bear capital losses.

Typically, gilt funds and medium to long duration funds follow this strategy. These funds are advisable for investors who can ride with the volatility associated with the fund. The funds can generate better return in a time when the interest rates are set to move downwards.

Accrual Based Strategy

Accrual strategy generally involves buying a bond and holding it till maturity to benefit out of the accruing interest income generated by the coupon bearing bond.

The funds which follow accrual strategy generally buy short term instruments and prefer to hold till maturity. This reduces the interest rate risk but typically invest in corporate bonds that provide good yields.

There are a variety of accrual funds available in the mutual fund industry. If an investor needs a steady return from his debt portfolio and is not ready to take high interest rate risk, he should invest in accrual based funds. Fixed Maturity Plans (FMPs), Ultra Short-term funds, Short Term bond funds, Banking and PSU Funds & Credit Funds follow this strategy. It is the credit quality that differentiates these categories of funds from one another. Typically, Ultra Short Term Funds, Short Term Funds, Banking & PSU Funds and FMPs have high quantum of corporate bonds in portfolio and have a reasonably high portfolio credit quality.

Credit funds take a slightly different approach:

Credit Oriented Strategy & Credit Funds

Although, these funds are also accrual funds, predominantly investing in corporate bonds, but their mandate is to invest across the credit spectrum. These funds invest in lower rated corporate bonds within investible limits that have higher coupon rate which enhances portfolio returns. The idea is to identify credit opportunities in the market which is normally done by credit research analysts.

Owing to this, these funds feature low on duration risk but high on credit risk. Consequently, the YTM of these funds is also relatively high compared to other debt funds. The fund manager does not target at making chunky returns through capital gains. He would rather focus on extensive credit analysis to identify corporate bonds that offer attractive yields, and which in his view offer adequate comfort of timely payment of interest and repayment of principal.

All fixed income portfolios broadly can be categorised under any one of the discussed strategies either singly or in combination. Nowadays scheme categories provide information about the base strategy of the fund. Investors need to compare the parameters of funds in one category with the category average, as this gives a sense of fund’s positioning and its riskiness. Matching the risk profile of the fund with your risk profile will provide much needed visibility and predictability of returns on your investments.

Illustration of how to pick debt funds

To simplify this further we take corporate bond category and compare the debt quants (MOD, YTM, Avg Maturity etc) of past 6 months. Under this category, fund houses are mandated to invest minimum 80% of its assets in high rated corporate bonds (AA+ & above), therefore these funds will not have much scope for credit risk.

Scheme NameMODYTM
Aditya Birla Sun Life Corporate Bond Fund1.
Axis Corporate Debt Fund1.
BNP Paribas Corporate Bond Fund2.
Canara Robeco Corporate Bond Fund2.
DHFL Pramerica Premier Bond Fund1.
DSP Corporate Bond Fund2.
Edelweiss Corporate Bond Fund2.
Franklin India Corporate Debt Fund2.
HDFC Corporate Bond Fund2.
ICICI Prudential Corporate Bond Fund1.
IDFC Corporate Bond Fund1.
Invesco India Corporate Bond Fund2.
Kotak Corporate Bond Fund0.
L&T Triple Ace Bond Fund5.
Principal Corporate Bond Fund1.
Reliance Prime Debt Fund1.
Sundaram Corporate Bond Fund8.
Tata Corporate Bond Fund1.
Union Corporate Bond Fund1.
UTI Corporate Bond Fund2.
Category Average1.941.771.751.761.861.768.

From this data we can gauge the industry view on interest rates. Duration of the category is rising month on month which means, broadly, industry expects the bond yields to go down from here or prices of the bonds to appreciate. When we look a little deeper, we find that L&T Triple Ace Bond Fund is the most aggressively positioned fund in the category. Its duration has gone up from 2.4 years in June to 5.7 years in November. Investors invested in this fund must have a long-term investment horizon and higher risk appetite.

Moving on, Tata Corporate Bond Fund and Reliance Prime Debt Fund look to be most conservatively positioned funds in the category. Their duration has been much lower than the category over past six months. These funds seem to be positioned for a short-term investment horizon of 1-2 yrs and suitable for investors having low risk appetite.

Edelweiss Corporate Bond Fund has been positioned little higher than the category in terms of YTM as well as duration. Investors in this fund may take a look at the portfolio composition and rating profile of this fund, as to generate higher YTM than the industry the fund must be subscribed to some high yielding corporate bonds. This fund looks ideal for investment period of three years and above and for investors having moderate – high risk profile.