Wish to invest in debt funds for long-term goals? Here’s help

Typically, people invest in debt funds for short-term goals. But what if you need to invest in debt funds for long-term goals as well?

I know you might ask as to why not stick to only equity funds when investing for the long term.

Not every investor is suited for a 100 percent or all-equity allocation. In fact, most investors are better off having some debt component even in their long-term portfolios. Something like 60-80 percent equity and the remaining 20-40 percent debt.

The reason for this is that an asset allocation-based approach is ideal for most portfolios as provides a balance between growth and stability.

So where to invest this debt portion of the portfolio?

Once you have exhausted the reliable and (still) tax-free options of EPF (and VPF), PPF, Sukanya Account, etc., you need to start looking at debt funds. More so when your portfolio size has grown large. At such times, debt funds can come in real handy when you have to rebalance your portfolio in both directions, i.e. from equities to debt in bull markets and vice versa in bear markets. This two-way rebalancing is difficult to achieve with illiquid debt instruments like PF, etc.

Debt Fund Categories Suitable for Long-Term Goals

For the debt side of your long-term portfolio, the following categories can be used initially.

Short Duration Funds - These invest mainly in bonds/papers maturing in a period of 1-3 years.

Dynamic Bond Funds - These funds have the freedom to invest in bonds/papers of any duration (from a few months to several years) depending on where the fund manager expects to earn good returns.

Banking & PSU Funds - These funds invest primarily in bonds/papers issued by banks, PSUs and public financial institutions.

Those who are willing to consider higher volatility in the short-term and/or are willing to take a bit more risk can consider these two categories as well.

Corporate Bond Funds - These funds invest primarily in high-grade corporate bonds/papers.

Gilt/Constant Maturity Funds - These funds invest mainly in instruments issued by the government across periods and primarily in government instruments across periods such that average maturity is constantly maintained around 10 years respectively. Since these are sort of government-backed, there is no risk of default. But these can experience sharp ups and downs because of changes in interest rates in the short term.

How to combine debt funds in the suggested categories?

Once you have shortlisted the categories, you need to pick a few schemes from them.

In debt, portfolios with different maturities behave differently based on where we are in the rate cycle. While picking funds, make sure you choose schemes across categories to combine portfolios of different maturities. That way, you will create an all-weather debt portfolio where you will not have to be constantly worried about trying to make a move based on the rate-cycle calls. While one category may not be doing well at a time, there will be another one in your portfolio that will compensate for it. You will not have to constantly change your portfolio every now and then and unnecessarily trigger capital gains taxation.

So a healthy mix of schemes with shorter and longer duration portfolios can work well for your long-term portfolio.

A few possible combinations are suggested below:

Combining schemes from the categories of Short Duration Fund, Dynamic Bond Funds, Banking & PSU Debt Fund, or

Combining schemes from the categories of Short Duration Fund, Dynamic Bond Funds, Corporate Bond Funds, or

Combining schemes from the categories of Short Duration Fund, Dynamic Bond Funds, Gilt/Constant Maturity, or

Combining schemes from the categories of Short Duration Fund, Corporate Bond Funds, Gilt/Constant Maturity, etc.

Note - Your unique requirements might demand a different mix. So be cognizant of that fact while picking, or take help from your investment advisor.

What about credit risk funds? While credit risk should be a complete avoid over the short term, it might still find its way into long-term portfolios via the above-suggested categories. That is fine but my view is that even for the long-term goals, the credit risk should be limited to a small exposure.

While picking schemes, give preference to funds that follow a conservative approach (and aren’t too adventurous) towards managing their portfolios. A scheme with a larger AUM and which has been in existence for several years is a better choice. Don’t be tempted by the high returns of a few schemes as these might be because of unnecessary risk-taking by the fund managers.

Note - MoneyControl has its own shortlist of investment-worthy debt funds in MC30.