How to Choose a Suitable Debt Scheme

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Returns from both equity and debt are equally affected by changes in economic and geopolitical scenarios across the globe. In equities we make losses when prices come down, while in debt we incur losses when yields go up. When there is higher demand for debt, the yields (the offered interest rate of papers) go up and hence the prices of existing bonds fall. This results in loss for existing bond holders since new investors chase those new bonds with higher interest rate. Interest rates are really hard to predict. Events happening worldwide affect the interest rates of every open economy. But one can generate decent returns out of this uncertainty if one’s portfolio mix is kept at optimal levels, though risks like default cannot be avoided. Let’s learn how.

Basic theory

Longer the average maturity of the scheme, higher will be the volatility or risk. Also, lower the credit rating of the papers invested into, higher is the risk. So conservative investors should choose short duration schemes and aggressive investors should choose long duration schemes. The NAV fluctuation will be higher for longer maturities than for shorter maturities since the chances of market interest rate variations are less during the short term. The risk in a debt scheme could be read from modified duration (MD) which is the percentage change in NAV of a scheme for 1% change in interest rate. MD will be lower for short term schemes and higher for long term schemes.

Interest rates and price of bonds are inversely correlated. When interest rate in the market rises, the price of bonds fall and when interest rates fall, the price of bonds rises.

Choice of maturity

Basic information one should keep in mind is that debt mutual fund schemes are classified mainly on the basis of maturity of debt papers they invest into. For e.g., a liquid fund invests in debt instruments with maturity less than 91 days; an ultra-short duration fund invests in papers with maturity less than six months; and so on.

Maturity is the most significant among all other parameters used to decide upon which scheme to invest. Various strategies come into play while selecting the maturity. These strategies depend upon the risk taking capacity of the investor. According to an unwritten thumb rule, one should match the investment horizon with scheme maturity. This means, if an investor intends to invest for three years, then he could invest in short duration schemes which has average maturity around three years and if the investor wishes to invest longer, then medium or long term fund is suitable. This is a conservative or passive strategy which does not yield the best returns always. One needs to dynamically manage the investments, redemption and reinvestment to make the best out of prevailing interest rate scenario.

There are two types of investors. One group wants to invest for long term and expect to receive cash flow out of their investment. The second group just wishes to capture capital appreciation opportunities over shorter periods of time, generally less than three years. Those looking for regular income and less volatility in capital choose short duration schemes and schemes with maturity less than three years. As we saw earlier, liquid or ultra-short duration funds are ideal for short term investments. But aggressive investors, in spite of their investment horizon, choose long bond funds even for short term investments. Suppose an aggressive investor wants to invest for 6 months and the interest rate forecast for the near future is negative (i.e., rates will come down). Then, it will be a great opportunity to reap the price appreciation on long duration bonds due to fall in yields of upcoming bond issues. But this scenario might not last long. Interest rates come down, reach a trough, and then can move upwards. In such a scenario the earlier profits may get eroded. So a dynamic management of schemes is essential. If you are aggressive about returns and can tolerate risk then you have numerous such strategies to adopt. But timing is very important.

Choice of papers

Here paper means bond instruments. When issued by the government it is called a bond and those issued by corporate entities are called debentures.

Government bonds are sovereign in nature and therefore, there is least default risk. You can get the promised money back. But since they are long term in nature, price volatility will be high. Since corporate debt is not as safe as sovereign debt, credit rating agencies have classified issuers of debt instruments into various categories depending upon their capacity to pay the debt back on time. General categorization spans through AAA, AA, A, BBB, BB and downwards. As we move down this alphabetical ladder, the credibility decreases and risk increases. Ratings from AAA till BBB- is considered investment grade. However, the current credit rating of a company is a reflection of its past credibility on loan repayments and not a forecast of future potential. Lot of Corporate bonds seldom carry maturities beyond 10 years. Most of them are short duration papers and interest paying ones and hence form part of short term schemes.

The new SEBI categorization of schemes have named a few scheme categories like credit risk fund and corporate bond fund. Credit risk funds carry higher risk papers such as those rated AA- and below, whereas corporate bond fund host papers with credit rating above and including AA+. Both these categories are short duration schemes with a maturity period of less than 4 years. Here, aggressive investors can choose credit risk schemes and moderate as well as conservative investors can choose corporate bond funds. When the interest rates rise a short term investor can benefit from increasing interest rates through coupon reinvestment gains. A short term coupon paying bond will generate higher yield till maturity (YTM) since each coupon (interest payment) is reinvested at higher interest rate resulting in final redemption being higher amount than expected. This benefit is not available for T bill instruments since they are non-coupon paying investments.

To conclude, there is specific scheme category to suit each investment requirement. One should learn the risk taking capacity, return requirement and scheme characteristics before taking investment decision.

Posted: October 2018

5 COMMENTS

  1. The explanation in this article is really informative! I will recommend this source to others especially to those who are beginners that are willing to learn to be a professional trader, thanks for the info!

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