How to build your debt portfolio

Investors spend a lot of time worrying about the equity part of the portfolio and don’t nearly pay enough attention to the debt portion. But you should be just as careful when building your debt portfolio.

A few things to keep in mind;

Don’t worry about chasing returns in your debt portfolio, that’s what you invest in equity for. When it comes to debt, the return of capital is more important than the return on capital.

Understand the two important risks in debt funds:

  1. Interest rate risk

  2. Credit risk or default risk

This thread explains what interest rate risk is. Just to reiterate, debt funds and interest rates have an inverse relationship. When interest rates rise, NAVs fall, and when interest rates fall, NAVs rise.

How much will the NAVs rise and fall?

As explained in the thread, this is where the concept of modified duration comes in. You can check the modified duration of a fund in its fact sheet. The higher the duration of a fund, the more volatile it is and the higher its sensitivity to interest rate changes. Here’s an example of the volatility of short, medium and long duration funds.

Credit risk or default risk is the risk of you losing your money. Debt funds hold individual long-term and short-term bonds. Every bond has varying levels of risk and this is denoted by a credit rating, here’s the rating scale of CRISIL.

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Every debt fund discloses its portfolio fortnightly. You can check the underlying portfolio to get a sense of how risky the fund is. Periodically reviewing the portfolio of a debt fund is important. Lower the credit rating, the higher the “potential” return but higher the risk.

When you are building your debt portfolio, you should always take interest rate risk and credit risk into account. You can invest in longer-duration funds as long as you understand how interest rate cycles work and that they can be volatile. But if you don’t have the stomach for interest rate risk, then you can stick to short-term funds or funds with lower duration. The duration range for each category is clearly defined.

Chasing returns in debt funds is a bad idea. Investing in funds with higher credit risk without understanding that high returns come with a higher chance of loss of capital can lead to mishaps. We saw this during IL&FS and DHFL crises.

Most funds with higher credit risk, like credit risk funds, haven’t exactly delivered in India. Their returns on 5 to 10-year periods are on par or less than much safer funds. When things go bad, you’ll lose most of your investment. Here are two examples vs a short-term fund.

Retail investors are better off avoiding risky funds and funds with higher credit risk. The risk to reward rarely makes sense. Stick to funds with high exposure to G-Secs, State development Loans (SDLs), and AAA-rate papers.

Another recurring mistake investors make is assuming that gilt funds are totally safe. Gilt funds only hold government bonds and there’s no credit risk. But most gilt funds hold long maturity G-secs and have a very long duration, and they have a high-interest rate risk.

The reason why investors ignore debt funds is that there are 16 categories of debt mutual funds. But the best thing you can do is first understand the basic concepts like interest rate risk, duration and credit risk.

This will make things much, much simpler when choosing debt funds. We highly recommend you check out the Varsity chapters on debt funds;

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  1. Post office Scheme.
  2. Bank Fixed deposits.

The foundation of debt portfolio should be the above two, later on the rest can be built on it. Give form 15G, TDS will not be deducted. Spread your funds in other family names. For NRI bank FD on NRE funds are tax free

Bank FDs are always ignored and sidelined. Not sure why?

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It’s wasn’t the case till 2 years back. There has been disruption in technology, instuments,knowledge ,direct debt MFs and current interest rates which makes bank FDs non lucrative. Also there has been so many banks having high NPA which can go down any day making large deposits not worth while. We can now buy bonds directly from RBI why to give bank commission when more or less banks also take money from same source RBI and take additional risk of default? With so many instuments available in fixed income segment, FDs has definitely lost its sheen! But for small money 5-10 lakhs FDs are still good as its doesn’t make sense to research about risk of different segment vs small reward . Govt gives 5 lakh garentee in case of bank defaults, so for them Fds are best.

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FDs have only one major advantage, instant closure and redemption. Any other form requires a couple of days for funds to become available.
So keep as much funds as you need for such scenarios in FDs but otherwise the Debt industry for retail has evolved significantly and that is why FDs have become less popular.
PPF is still a good option and so is post-office but all have their pros/cons so its a custom choice.

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Do you really think that a scheduled private bank (not a coop bank) can go down any day? I do not think so. Banking is one industry, since it accepts public money, will not be allowed to fail. The simple example was Yes Bank. The industry is well regulated by RBI. Banking is one of the safest sectors. It is just not right to compare Bank deposits with that of Corporate Bonds from safety perspective

What commission do you pay when you place a FD with Bank. Not clear. In fact when you buy Corporate Bonds, you need to pay commission to the broker or distributor.

Bank deposit continue to be the safest form of investment and if Banks can fail any day, then all of the corporates who have issued bonds can fail any second.

Disclaimer: These are my personal views and fully believe in FD as the back bone of any debt portfolio. FT was another classic case. Now we have Axix Mutual Fund

Leman brothers ,4th largest bank in the world that time closed its door overnight in 2009. There is always first time for any black swan event and with current NPAs, risk can’t be neglected even though cances are low.And the uncertainty you will face while not able to access your money for weeks and months ,it happened with Yes bank as well. You will have sleepless nights.With so many different fixed income instuments you may easily diversify your credit ,interest rates,default risk.

What i meant by commission is the working capital you indirectly pay to the bank. Bank gives 5% interest currently while current 10y bond yeild is 7 % so its actually 2 % you are paying to bank( This calc is just at very high level ,deriving actual value is very complex.My point is FDs interest will always be lesser than whats offered by RBI GILT). This how bank earns and FI MF commison is less than 0.4%

Also FT saga you mentions it just took RBI single day to manage the event though money got blocked but the thing is every one diversify in debt funds across funds and AMCs and scehemes so i don’t think hardly anyone more than 5% capital got stucked which they got back already. Axis is related to equity scheme , don’t get it mixed with debt scehme, there is no issue.

Also , I have nothing against FDs or banks.For day to day activities you need liquid /cash and some FDs also good for diversification. But i think people should explore more in FI covered bonds,debt mutual funds, SDLs, Govt bonds, GILTs as now its very easy to diversify and get better returns than FDs.

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