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Way back in 2015, when the Amtek Auto debacle was being brushed aside as an aberration of sorts, Mahesh Mirpuri was constantly cautioning investors of the risk in debt funds.
Be it the mainstream media or social media (you can follow him on Twitter), I’ve kept throwing questions to investors: Are you aware of the risks in Credit Opportunities funds? Are you prepared for a credit event? Are you choosing your funds wisely? Are you playing it safe when it comes to debt funds?
Here, Mahesh Mirpuri, financial coach and adviser, guides investors on how to build a debt portfolio.
The first step to creating any portfolio, is to decide on the equity and debt combination. The allocation to equity will rest on three factors: when you need the money, an honest appraisal of your capability for risk, and the volatility you can stomach.
When it comes to debt, there are two aspects you must never lose sight of: Safety and Liquidity. I say this because the prime aim of a debt fund is capital preservation and stability to the overall portfolio. It is supposed to make it easier to stomach risk elsewhere in the portfolio. Investors can inadvertently sabotage their portfolios by trying to juice returns by adding risky debt.
It is very easy to get carried away by advice doled out of Twitter or television. Random transaction-based investing will harm you and you will end up with a lot of “junk”. To safeguard against that, never view any investment in isolation, always view it in relation to your portfolio. Once you adopt this step, then you will get investments that complement each other, at the same time, avoiding portfolio clutter and duplication.
There are three elements to consider when constructing a debt portfolio.
- An Emergency Fund
An emergency, by its intrinsic nature, is meant to urgently cater to the unexpected. Which means, you will need the money instantly. Don’t chase returns here, keep a laser-like focus only on Liquidity and Safety. This is all that matters. I suggest a bank fixed deposit. If you want to consider mutual funds, go for liquid and ultra short-term funds. Alternatively, you can consider dividing the emergency fund among these options.
Liquid funds primarily invest in money market instruments like commercial paper (CP), treasury bill (T-bills) and certificate of deposit (CD) with low maturity period.
Ultra short-term funds primarily invest in liquid fixed income securities which have short-term maturities.
- Core Portfolio
This bucket contains the bulk of fixed income allocations and provides for a nest-egg to the overall asset allocation of an investor. The chief pursuit here is one of safety.
I suggest you layer it.
Look at assured return investments such as fixed deposits, Employee Provident Fund (EPF), Public Provident Fund (PPF), RBI bonds, and small savings schemes.
Build on this base with debt mutual funds that are low on both, duration and credit risk. Do not deviate from this rule and you will avoid credit risk and interest rate risk. The advantage of such debt mutual funds is that investors get the benefit of lower tax rates (if held for> 3 years) and market returns. The appreciation in these funds is not only from the accrual of interest income, but possible capital appreciation due to interest rate movements.
- Tactical Portfolio
This is where you can afford to be experimental and look for higher returns. To take advantage of market conditions, 15-20% of your debt allocation can be funnelled into this bucket.
Gilt funds would fit here. These funds have no credit risk or risk of default. Their risk is interest rate movements. If you expect interest rates to dip in the future, you could consider a tactical bet here.
Dynamic bond funds would fall under this category. Consider them after getting well acquainted with the fund manager’s strategy. Steer clear of funds with credit risk.
Credit risk funds too fall in this satellite category. These funds do not even come onto my radar as I see no point in taking on risk of default and wiping out capital permanently.
Non-convertible debentures (NCD) issued by companies also fall into this category. But the risk here cannot be ignored.
A word of caution to retail investors when it comes to debt funds.
- Start with the question: why do I need market-linked debt instruments? Once that is answered, take it forward using safety and liquidity as the two guiding posts.
- Understand the nuances of each fund. Different types of debt funds carry different risks. The risk of a credit fund is totally different from that of a gilt fund. Gilt funds, on the other hand, are not a homogenous lot. The category has actively managed gilt funds and constant maturity gilt funds. Understand what the fund invests in and its risks.
- When evaluating a fund, keep various factors in mind; whether it is purely open ended or a “target maturity” fund, weighted average maturity, credit quality and expense ratio. Liquidity of the portfolio must also be considered. Your open-ended debt fund must be able to provide for liquidity in the assets that it holds. This means that when faced with redemptions it should have assets that can be liquidated and with reasonable impact costs. When selling assets, the risk profile of the remaining assets should not shoot up or be concentrated, like we have seen in the recent credit fund crisis.
- Finally, don’t invest ONLY because the past performance has been great. This is a mistake many a retail investor is susceptible to.
If all of this seems a bit overwhelming, I suggest that you take the help of a knowledgeable guide or a financial adviser.
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