How to use debt funds in Prime Funds in your portfolio

Please note that taxation of debt funds have undergone a change. Indexation benefits will not be available for investments made from April 1, 2023 onwards. You can read all about this change in our article ‘Tax changes in mutual funds: How to manage your investments now‘.

This is the second to our three-part explanation on how we construct Prime Funds and how to use these fund recommendations to decide allocations. In the first part, we had covered equity funds in depth. In this Part 2, we will cover the debt fund recommendations in Prime Funds.

Debt funds – the approach to classification

Debt funds, like equity funds, can lead to missed opportunities if you rely simply on the SEBI categories (not to mention that the classification is far too confusing, given the incredible sixteen fund categories!). SEBI categories are defined either by the maturity of the portfolio, by the type of instruments they hold, or by their credit profile. The category mandate specifies only one of these three criteria.

What does this mean? Those two funds could belong to the low duration category, but one can be much higher risk because it invests in low-rated debt. Those two funds could belong to the corporate debt category, but one could be less volatile because it has a shorter maturity. That one fund could be a banking & PSU fund but be very similar in returns and volatility to a short duration fund.

Therefore, the following are the drawbacks in going only by SEBI categories:

• You may inadvertently take on more risk because the fund category masks its credit profile.
• You may miss out on opportunities in some fund categories because you do not know these can fit your requirements.
• You may wind up with too many funds, along with overlaps if you aim at holding a particular set of categories.

Let’s explain further. 

Consider a timeframe of 1 to 1.5 years. You decide to go for money market funds, as they keep an average maturity of about 1 year. But then, ultra-short-term funds may also be just as good, given that they invest in very similar instruments. So could low duration. When rate cycles turn upward, funds with shorter maturities could in fact deliver better in the near future than those with longer maturities.

Or consider longer timeframes. You may want to then pick up funds only from the long duration category. But these can be volatile because they need to maintain that 7-year maturity. But a corporate bond fund could be far more nimble, far less volatile, and deliver just as well if not better.

Therefore, trying to have specific debt category representation in your portfolio is not the best idea. The key in debt funds is to go by your holding timeframe. The table below explains how different debt categories fit each timeframe.

That said, there are some debt categories we do not think are necessary for portfolios – these are the long duration and medium-to-long duration categories. These funds make returns primarily from a duration strategy; the same can be got from gilt funds. This apart, their category mandate prevents them from reducing maturity to deal with different rate cycles, and this ups their risk. Sticking to other fund categories (as we’ll explain below) will be a better strategy.

As mentioned, your timeframe is the root of all debt fund decisions. Accordingly, we have classified the debt portion in Prime Funds based on the minimum number of years (or months) you need to hold. 
So, when you want to invest in a debt fund, first fix your minimum timeframe. Then go to the Prime Funds set that matches this timeframe. We also suggest you understand the two fundamental concepts in debt – accrual and duration.

Less than 3 months

This is pretty straightforward – we only look at liquid funds when your holding period is a few weeks to 3 months. These funds are also great for emergency portfolios (since they are very low risk). You can add on overnight funds if you wish to, if you have a large corpus to invest. If you are in the highest tax bracket, you can also mix these funds with arbitrage funds (more about this in the next article) if you want to reduce the tax impact. 

You can go for one or more funds, based on the amount you are investing. But note that there’s no real benefit in owning too many liquid funds as they are very similar to each other in risk or return. Finally, if you are looking for liquid funds to run an STP, then Prime Funds won’t be of much use here, since your choice will be dictated by the equity fund you choose.

Very short-term: 3 months to 1.5 years

This Prime Funds set is meant for very short-term holding periods. In these recommendations, we prioritize safety over returns. Therefore, we do not recommend funds that take high exposure to papers rated below AA+. 

At any given point, this set will contain a mix of funds from the ultra-short, low duration, money market and floater fund categories. We do not seek to necessarily have funds from all these categories, and there may be times when we don’t have a floater fund, or a low duration etc. Our calls are based on the fund performance, yields, maturities, and the rate cycle. This set of funds may also see quicker changes than the other Prime Funds.

How to use: These funds are good fits for goals that are at least 3 months to 1 year away. While they are low volatile by nature, this does not mean nil loss probability. They can dip from week to week, though they rarely register declines over even 1-month periods. Guidelines in using these funds are as follows:

• They are suitable for any investor, for any risk level. Remember that a short holding period does not allow you to take risks, so do not go including equity or hybrid funds here. The most you can do to diversify is to add fixed deposits, if they have good interest rates!
• They are ideal for very short-term holding periods of up to 2 years. You can use these funds entirely for the goal. If your investment amount is very large and your timeframe is on the shorter side, consider mixing them along with liquid funds. 
• You can also use these funds when you are shifting away from equity towards safer instruments when you near your goal. 
• They are also useful to deploy surplus money at times when the interest rate cycle is on the cusp of a shift upwards. This will help you tap the improving yields before the longer-term debt funds that you may hold. For those especially wary of volatility or any risk in debt, they can even be held for timeframes longer than 2 years – all that will happen is that you see lower return.
• They are good fits for income generation through SWPs – their low volatility and low risk allow you to set up an SWP shortly after investing. In this case, make sure to keep your withdrawal rate within about 6-7%, to limit the risk of drawing from your capital. We have discussed SWPs in detail in this article.
• Spread your investments across at least two funds, unless your investment amount is small. Ideally, don’t allow any fund to be more than 25%-30% of your portfolio. You can mix funds with different maturities, or mix categories here. You can also add liquid funds, as mentioned earlier.

Fund differences: Primarily, these funds are similar in terms of where they invest and the way they return. Some funds, such as Axis Treasury Advantage could take marginally higher risk (less than 5% of portfolio) which places them slightly above the others in terms of risk profile. However, returns are also typically higher. You can mix such slightly better-returning options along with the very low-risk ones, if the slight credit risk bothers you. Read the ‘Why this fund’ in our Prime Funds page to know the fund’s type, strategy and suitability.

Short-term: 1.5 to 3 years

This Prime Funds set features funds that you can invest in if you have at least 2 years in the holding time frame. This set uses the short duration, floater, and banking & PSU funds categories. Each category has its own unique feature – banking & PSU funds make superior returns during rate corrections. Floater funds excel as interest rates make the changeover from flat/low into rising. Short duration funds offer accrual returns. This blend, therefore, offers opportunities across the rate cycles.

While credit risk is still key in these timeframes, some allocation to low-rated papers is acceptable. When such credit calls are taken well and form a small part of the portfolio, it keeps yields and returns better. When we choose funds, therefore, we look at concentration in credit, the nature of issuers, trends in credit calls and so on before taking a call. 

How to use: The short-term Prime Funds category is a very versatile one. While the most straightforward use is for short-term goals, they can be part of different portfolios. Here’s how to use these funds:

• Can be used by any investor to invest towards goals that are a minimum of 2-3 years away. These funds can be mixed with Very Short-Term funds as well, for short-term goals.
• Can form part of the debt component for asset-allocated portfolios, short or medium or long. For example, a 3-5 year portfolio can have anywhere from 50-85% in debt. You can use these short-term debt funds for this purpose. Given the range of fund strategies in our recommended list, you can have a diversified debt allocation. For example, adding in a floater fund could help hedge interest rate risk and come in handy during rate upswings. You can also mix these with Very Short-Term Prime Funds or Medium Term Prime Funds (explained in the next section). Look at our 3-5 year Prime Portfolio, for example. 
• Combining a short and long maturity fund reduces the interest rate risk and overall volatility. Our 5-7 years Prime Portfolio, for example, uses such a combination. In fact, if you are especially averse to debt fund volatility, worrying about returns dips in longer-term debt funds, then you can entirely stick to these Short Term funds. 2-3 years is only the minimum for which you hold – you can go any number of years beyond that.
• Can form part of a post-retirement portfolio. Once you have set up the low-risk, guaranteed return investments (see our retirement portfolios to know) you can begin adding these funds for their tax efficiency (compared to fixed income interest-paying options) and their return potential. You can set up SWPs from these funds once you cross the minimum holding period.
• Pay attention to the credit risk. For the risk-averse or who do not understand credit, restrict to the funds that have no credit calls. We would have mentioned this in the ‘Why this fund’. Since no fund is high risk here, you do not necessarily need to mix these with low-risk funds. 

Fund differences: As mentioned above, this Short-Term Prime Funds set uses different categories to offer a strategy variety. Don’t directly compare returns or portfolio yields, because both are a factor of the fund type and the rate cycle. 

Banking & PSU funds may have higher volatility, but are usually low on credit risk. They shine during falling rate cycles. Go for floater funds if you want to manage the uncertainty over interest rates or when rates are heading upward. Short duration funds are stable and can be part of any portfolio at any time. Banking & PSU and floater funds can be combined with short-duration funds to pick up different opportunities. Depending on your purpose and investment amount, try to use at least 2 funds. Read the ‘Why this fund’ to know the fund’s type, strategy and suitability.

Medium term: 3 to 5 years

This Prime Funds set is meant for goals that are at least 3 years away. At this time, we have restricted our choices only to the corporate bond category. For this timeframe, this category appears the best-suited. 

They don’t go overboard on maturity, still offer capital appreciation when duration strategy works, and offer accrual returns during rising to flat rate cycles. We may add funds from other categories such as medium term here – but we find that their credit calls are a huge risk and performance does not match up to that of corporate bonds across parameters.

How to use: These funds are good fits for the debt portion of long-term asset-allocated portfolios. Note that these funds can see volatility as their longer-term bonds react to rate cycle changes. They may also deliver low returns – especially during low to flat rate cycles - in periods such as 1-2 years. You will need to hold beyond this period for returns to pick up. Broadly, you can use these funds as follows:

• They suit any investor for goals that are a minimum of 3 years away. 
• Can be used for the debt allocation of asset-allocated portfolios, starting from 3 years and going up to any timeframe. Allocate anywhere between 20% to 40% to these funds (depending on timeframe – higher if your timeframe is shorter and vice versa), even if you are a high risk-taker.
• To reduce the impact of interest rate changes on your portfolio, you can pair these funds along with Short-Term Prime Funds. A blend like this will also help those who cannot handle the increased volatility and risk in corporate bond funds. You can either make an even split (depending on your allocation), or have a higher allocation to these Medium Term funds and a smaller one to the Short Term funds.
• Can be used in post-retirement portfolios as well, for their better tax efficiency and return potential. Make sure to hold for the minimum timeframe, and use them along with shorter-maturity debt funds as mentioned in the earlier sections.

Fund differences: All funds are corporate bond funds. However, they differ in the average maturity they adopt. The longer-maturity funds can be marginally more volatile. Read the ‘Why this fund’ to know the fund’s type, strategy and suitability.

Long term: above 5 years

This Prime Funds set is meant only for long-term portfolios, for the debt allocation that they require. Apart from corporate bonds (that also form part of the Medium-Term Prime Funds set), this set also has constant maturity gilt funds and credit risk funds. We have also featured dynamic bond funds in this set. As explained in the initial section, we do not consider long duration and the medium-to-long duration categories.

The idea behind this is as follows: funds bear risk either through interest rate risk or credit risk.  Longer the duration (maturity) of a fund, higher is the volatility. This calls for patience. Similarly a fund loaded with credit risk needs time to repair any damage arising from credit hits. Hence a longer holding period is called for. Thus, both risks even out over the long term, making them suitable only for long-term holdings. 

Gilt funds carry zero credit risk. Going for constant maturity funds brings in certainty about the maturity profile and strategy of the fund.Similarly, credit risk funds involve high risk. Should any credit event take place, which hurts the fund due to write-offs, defaults, or downgrades, the long timeframe allows you to recoup the losses.

How to use: These funds are best used as debt allocations in portfolios where you have at least 5 years in holding. Following are guidelines to use:

• Ideally, you need to have at least 20% in debt allocations in these long-term portfolios. Pick the fund based on your risk profile.
• If you cannot handle volatility or any period of low returns, go for the corporate bond funds. Avoid the gilt constant maturity funds. As explained in the Medium-Term section above, you can use these longer-term funds along with shorter-maturity funds to spread out your return opportunities. Split the allocation evenly among the different funds, or give a higher weight to the Long-Term funds.
• If you do not wish to take on any credit risk but can take some return fluctuations, go for constant maturity funds. Having at least a 6-7 year timeframe for this is possible. Be fully prepared to see losses even in 1-year periods and hold through poor return periods. For an invest-and-forget approach, the constant maturity funds work very well. They are good fits when the debt allocation is simply to balance equity risk in very long time frames of over 7 years (i.e., your intention over longer time frames would be to focus on the equity returns and not worry about whether the debt allocation is positioned to make the best return in every rate cycle). Our 7-year readymade Prime Portfolio is built on this concept.
• You can also mix constant maturity funds with corporate bond funds, especially when you are trying to diversify debt allocation or it is higher than 20%. Use an even split, or allocate based on which factor you prioritise more. 
• Go for credit risk funds only if you understand the risk involved. Remember that write-offs/ defaults can wipe out a chunk of returns at one go. Do not make these funds the only debt allocation – always use high-quality funds along with them. Cap allocation to 10%. 

Fund differences: The corporate bond funds overlap with the Medium Term funds – since these funds can be held for any timeframe longer than the minimum. The constant maturity fund, of course, scores on credit quality and will deliver well over the long term but will be volatile. The credit risk funds hold the highest risk, even if their returns don’t fluctuate as much as other fund categories. Do not compare returns between these funds as they are a factor of the risk they take, their maturity and the rate cycle. Read the ‘Why this fund’ to know the fund’s type, strategy and suitability.

If portfolio building seems too complex – you can invest in our Readymade Portfolios or use them as guides. We’re also working on developing a ‘Build your own portfolio’ tool, which we hope to set up in a few months.

Related Articles :
Prime Funds: How to build a portfolio with the right allocations (Part 1)
Prime Funds: Using hybrid funds in your portfolio (Part 3)