In general, the higher the duration, the higher is the interest rate risk
Are you aware of the number of categories of debt funds?
For the uninitiated, the answer is 16. Yes. That’s not a small number. And hence, it’s natural for retail investors to feel confused as to which categories are suitable for their investments. On the shorter side of the debt fund maturity spectrum, lie three categories that many investors are interested in: ultra short duration, low duration and short duration funds.
What is the difference among these categories and how should you choose what is suitable for you?
Segregation based on maturity
At a very basic level, the categorization is based on the maturity profile of the funds.
That is, the funds in these categories invest in debt and money market instruments so that:
-Ultra-Short Duration Funds - Macaulay duration of the portfolio is 3-6 months
-Low Duration Funds - Macaulay duration of the portfolio is 6-12 months
-Short Duration Funds - Macaulay duration of the portfolio is 1-3 years
The Macaulay duration is a technical term. But simply speaking, it refers to the weighted average maturity of bonds/papers in a fund’s portfolio after factoring in all the cash flows.
In general, the higher the duration, the higher is the interest rate risk. Since low-duration funds take a slightly higher duration stance, they also carry higher interest rate risk. Similarly, short duration funds carry higher interest rate risk than low duration schemes.
One thing that most investors don’t realize is that if the average duration is 3-6 months (like for Ultra-short duration funds), it doesn’t mean that all the papers/bonds held by the fund will be maturing in 3-6 months. It is just the average profile of the fund’s portfolio. So some bonds in the portfolio would be maturing in the next 1-3 months while some other might be maturing in the next 2-3 years!
Sounds odd right? But that is how averages work.
And there is another aspect to this. Due to the mismatch between the average maturity figure and the actual individual maturity timelines, the funds may carry a little more interest rate risk than what their category (or average maturity profile) might tell you. So you need to be careful about what you see and what you make of it.
What about credit risk?
Structurally, ultra short duration and low duration funds are more suited for taking lower credit risk due to their shorter maturity profile. Short-duration funds on the other hand can take comparatively higher credit risk as they have the comfort of the longer maturity profile for their portfolio.
Sadly, the existing categorization guidelines only refer to the duration of the scheme portfolios. Nowhere does they prescribe any credit rating profile for these three categories.
So, fund managers are free to take as much credit risk as possible to try and generate extra returns. This will work at times. But it may also not work occasionally. And this is what happened in the on-going debt fund fiasco of Franklin India AMC. Try to understand it like this.
Suppose you want to choose between two ultra-short duration funds, namely A & B. You check the maturity profile and it’s within SEBI specified limits of 3-6 months. Now you look at the historical returns. You see that the fund A has given much higher returns. You decide to figure out the reason for this outperformance. You open the bonnet (check funds’ portfolio) and realize that fund B has 95 per cent of its assets invested in high-credit (AAA) rated papers. On the other hand, fund A has invested only 25 per cent in AAA-rated papers, while the rest of it is parked in lower-rated, riskier but high-yield securities. So the fund manager of fund A is taking extra credit risk to generate high returns.
Since we are talking about debt funds, it’s best not to take too much risk in debt. Risk taking should be limited to the equity side of your portfolio.
So, when should you invest in these three fund categories?
Ultra short duration and low duration funds can be used for short-term investments which are due in more than a few months, but up to a few years. Short duration funds are suitable as the debt component for medium to long-term portfolios. It’s not suitable if you plan to park your money for just a few months or 1-2 years. But having said that, even ultra-short and low duration funds can also be part of your long-term portfolio. Or, one can hold a combination of these categories to have a well-diversified (maturity timeline) debt fund portfolio.Choosing debt funds is not easy, though it’s simple. Do not go after high returns alone. Stick to large well-diversified debt funds that give reasonable returns but don’t compromise on credit quality and hold highly-rated securities.