When interest rates are falling, it is a good decision to be in long-term debt funds.
Most investors tend to focus on the portfolio of equity-oriented mutual fund schemes because it is directly related to the stock market performance. However, as far as debt funds go, the attention given is much less as it is always assumed that these are fixed-rate instruments and cannot default. Of course, there is the additional factor that analysing the debt portfolio is more difficult than equities. But it is important that investors acquire this know-how as well because it will help them make the right decisions. Here are a few pointers:
Portfolio concentration: Perhaps, this is the most important point to look for before buying a debt fund. There are times when the entire portfolio might consist of just one or two instruments. It often happens in situations when the corpus of the scheme is not very big, like Rs 30-50 crore. This leads to investment in only a few instruments.
Clearly, this means that the fund is riskier. Even a slight change in the prices of these securities can lead to a sharp rise or fall in the fund's returns. Also, there is the additional problem of liquidity because selling a large holding is often a rather difficult task.
Ratings and holdings: The type of instruments selected in the portfolio is also of significance. This will determine the credit risk for investors. In debt portfolios, there are various categories like bank fixed deposits, certificates of deposit, commercial paper, treasury bills, pass-through certificates, government securities and others. Each of these papers has a different risk weight attached to it. A fund manager normally tries to balance the risk element with the safety of the instrument.
This is because while there is a higher interest rate in some papers, there is also a risk element. Whereas government securities are safe, returns will also be correspondingly lower. Normally, there is a credit risk rating by rating agencies like Crisil, Icra and others, which a fund manager uses to gauge the overall risk of the portfolio.
For an investor, higher-rated holdings are a good sign that their returns are safe, but entire portfolios in safe papers also mean that returns will suffer. A good amalgam is what an investor should look for.
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Kinds of instruments: All the instruments in the portfolio have to be analysed in terms of their features. For example, if the instrument is a corporate paper, the yield here will be higher than that of several safe instruments. In good times, a corporate paper will positively impact the portfolio's returns. Often, there are situations where there is an asset-liability mismatch between the instruments in the portfolio and the nature of the scheme.
So, a short-term scheme might have long-term papers. Such a situation means that while the fund house has borrowed for the short-term, say three months, it has lent for a longer period. While this ensures better returns, it also means higher risk. It is important to understand this risk because, as we have seen in recent times, if there are redemption pressures on such schemes, fund houses find themselves in deep trouble because they are holding long-term papers. And to pay back clients, they have to sell these papers at a discount in the market. This leads to a fal in net asset values (NAVs) for existing customers.
Maturity period: The maturity period of instruments in the portfolio is also a very important factor. For one, the returns for instruments with various time maturities will have specific yields that vary according to the time and the instrument. So, in case of an expected fall in interest rates, a longer-maturity portfolio will be expected to give a higher return. In case of a rise in interest rates, it is in the interest of the investor to have a portfolio with a shorter-maturity time.
The writer is a certified financial planner.