Corporate bond funds, gilt funds and credit risk funds – which to own and when?

When it comes to building long-term portfolios with debt, many of you are confused about which funds to use. Should it be corporate bond funds or gilt funds or credit risk funds? To choose these or a combination of these, you need to first know the difference in the characteristics of these fund categories. 

If you are familiar with the characteristics of these fund categories, skip and go to the last part on Comparison and Which ones to hold.

What are corporate bond funds?

The category name ‘Corporate Bond Fund’ – as coined by SEBI’s categorization rules – is a bit of a misnomer. After all, a corporate bond is any bond issued by a company. It can carry any credit rating or tenure. Ultra-short, low duration, short duration, medium duration, dynamic bond, banking & PSU debt and even credit risk fund categories all hold corporate bonds! 

Anyway, as far as the corporate bond category goes, SEBI has specific definitions in terms of portfolio. SEBI specifies that Corporate Bond Fund as a category should have a minimum of 80% in corporate bonds. It further states that 80% of the portfolio should be AA+ rated or above. In other words, the bonds held by this category must be of high-quality credit. So essentially, this category allows you to hold papers with high credit quality. 

Does that include sovereign papers – otherwise called government securities (G-secs)? Yes. The data below will tell you that corporate bond funds on an average held 17% to G-Secs as of August 2022.

SEBI does not specify the average maturity that funds in this category should maintain – unlike, say, the low duration or ultra-short-term categories. But based on rate cycles, funds tweak their portfolio maturities from 1 year going up to even 6 years. 

Therefore, this category is typically recommended for a longer-term holding period of 3 years and over. Essentially, this is a category where you need not worry about taking credit risks. It therefore fits any long-term portfolio. 

And, importantly, it does not take very high duration risks. This is because most corporate bonds have a 2–5-year tenure. This automatically means that funds cannot drastically change their duration like dynamic bond funds or hold very high maturity papers like gilt. That also means that this category will be less volatile than gilt. We will see more data on that later.

Where the return comes from: Corporate bond funds earn their returns through 2 sources: one accrual (coupon income) and two, duration. As corporate bonds have a spread over G-Sec returns for the additional risk that they carry over a sovereign instrument, their interest income tends to be more than G-Sec. On duration, corporate bond funds are restricted in terms of how much they can deliver as capital appreciation (they do, but not high) compared with gilt funds. The latter predominantly delivers on capital appreciation during favourable rate cycles.

Gilt funds/constant maturity funds

These funds have to invest at least 80% in G-Secs. Gilt funds can invest with any duration (funds’ maturity range from 1.5 years to 9 years currently). Constant maturity funds have to maintain their duration at an average of 10 years at all times.(A constant maturity fund is different from target maturity index funds/ETFs and we have explained it in this article). 

These funds hold G-Secs, state development loans (SDLs) and some amount in treasury bills. This makes them highly credit-worthy. However, they can be very volatile, especially when the rate cycle moves up. We will see more about this later. 

The key difference between these funds and corporate bond funds is that they cannot invest in instruments other than government securities (for at least 80% of their assets). These funds can also go to much longer maturities. While gilt funds can modify their duration, most of them tend to carry medium to long duration papers. They too need a longer term holding given that they can be volatile in the short term.

Where the return comes from: Gilt funds and constant maturity funds also earn returns from the coupon interest. However, gilt funds tend to gain far more significantly during interest rate falls and the ensuing price rally in G-Secs. The longer their average portfolio maturity, the higher the rally. This adds to the NAV’s returns. In the case of constant maturity too, there is NAV appreciation when rates fall, but they cannot dynamically tweak their duration. Hence returns can, at times, be capped. But they are more predictable as their maturity remains constant (at 10 years). 

Two categories that also need mention here are the medium-to-long duration and long duration. We typically don’t favour these categories. For one thing, compared to corporate bond funds, they need to maintain a much longer maturity making them more volatile and there are no specifics on credit quality of the portfolio. For another, for such long maturities, gilt funds are superior options as they are not restrained by duration (like medium and long duration funds) and do not take credit risk.

Credit risk funds

This category of funds, too, invest in corporate bonds. Just that they invest where the corporate bond fund category is not allowed to! SEBI requires credit risk funds to hold at least 65% of their assets in instruments that have credit rating of below AA+. That essentially means they will predominantly hold higher risk papers. 

Between 2018-20 a series of credit events led to many funds from this category toning down their credit risk profile, as regulations also forced them to provide more liquidity (hold liquid instruments). As a result, this category reduced its credit profile. At present, credit risk funds, on an average, hold just 51% of their portfolio in instruments below AA+ (Aug-21). But the credit risk is still higher than all other categories and hence these funds require a longer holding period to absorb any such risk. Given the high risk involved in their papers, they tend to keep average maturity at under 3 years on most occasions. This helps avoid interest rate cycle related risks.

Where the return comes from: Returns for these funds come predominantly from the interest income. While this category used to sport very high yield to maturity (YTMs) given the low credit quality of papers they held, with funds now increasing credit quality, the yields are less attractive than before. 

Still, the YTM of this category on an average increased from 6% in March 2022 to 7.4% in August 2022 (that of corporate bond funds stood at 6.8%  as of Aug-22).The higher-yielding funds in the credit risk category which additionally have seen lower past defaults and downgrades are listed in our Prime Funds, under the Debt - Long Term category.

Since credit risk funds do not play around much with duration, there is not much scope for capital appreciation here. Returns are less volatile and more predictable - provided there are no sharp downgrades and defaults, compared with the other 2 categories discussed above. This category also carries the highest credit risk compared with all debt categories.

The comparison

Corporate bond funds are less volatile than gilt funds. The data below will tell you this, especially over rolling 1-year periods. Credit risk funds can be highly stable if there isn’t any credit event but then can become highly volatile and see further dips in returns when there is a downgrade or default.

Given that many credit risk funds have faced multiple write-offs and write backs, a meaningful comparison with other categories is not possible for the below metrics. Suffice to say that credit risk funds that did not take a hit have lower volatility.

The data above clearly indicates that corporate bond funds have lower volatility than gilt funds, primarily because they operate within a narrower range in terms of average maturity of the portfolio. 

While the average returns of the gilt category appear higher, note that the period we took for the data contained longer periods of rate falls than hikes (for 1-year rolling return, the NAV period started in 2018, for 3 years in 2016, while for 5 years the Nav period started in 2014). In a steep rate hike (such as the present one) periods, corporate bond funds score over gilt funds. Data below shows how even longer period point-to-point returns were dented more in gilt, due to the recent rate hikes.

Which ones to hold?

• A corporate bond fund, because of its lower volatility, fits even a 3-year portfolio (minimum time frame). You can hold these funds for any length of time beyond this. These funds can also be the only part of your debt portfolio, if you wish to avoid the higher volatility that comes with gilt funds. If your overall Sip value is low and you can accommodate only one fund, then you can hold this for the time frame we mentioned above.
• A gilt fund is better when you have a minimum 5-year view. It can also be held for any number of years beyond this minimum. Gilt funds can also be the only debt component of your long-term portfolio. However, be aware that these funds can look extremely unattractive in periods of rate hikes (as they do now – see table above). They can sport losses or very low returns -  much more than corporate bond funds. You need to be able to remain invested through this low phase. 
• If your SIP or investment value is high, you can even combine gilt funds and corporate bond funds in your 5-year plus portfolios. Since both corporate bond funds and gilt funds invest in different instruments and mostly with different duration, they can complement each other. The corporate bond fund will provide some accrual and the gilt fund will help play the duration. 
• Gilt funds can sometimes require some profit booking, especially when returns move to double digits in rate fall phases. Corporate bond funds would need less maintenance on this front.
• Credit risk funds are only if you are eager for those few basis points of higher returns for timeframe of 5 years or more. They are eminently skippable, especially in a conservative to moderate risk portfolio. 

To tide over phases of volatile returns, whether in corporate bonds or gilt funds, consider adding some ultra-short and short duration funds as well even if the portfolio is a long-term one. Adding such short-term funds will help compensate for the period of low returns that gilt funds sport during rate hike phases. You can also hold stable traditional options such as fixed deposits for shorter periods along with these debt fund categories. You can also read this article where we answer several questions relating to debt portfolio building.