With the revised classification norms given by SEBI, it is expected that choosing debt funds will become easier. Well, there would still be 16 debt fund categories. Is that simple? How should an individual investor pick a debt fund for his/her goals?
In Oct 2017, SEBI, the mutual fund regulator, issued a circular to reclassify all mutual fund schemes as per the category definitions it provided. The primary purpose of this exercise was to help retail investors make sense of schemes. Currently, several schemes within the same fund houses end up looking duplicates thus confusing the investor.
The new norms will ensure that funds fall under predefined categories with uniform descriptions so that the investors can make an informed decision.
Choosing debt funds – is it really becoming easier?
Now debt funds always tend to confuse investors badly. The recategorisation should be make easier than before to choose debt funds.
First, let us try and make sense of the new categories.
As I mentioned before, SEBI has now defined 16 categories of debt mutual funds. One of the crucial parameters SEBI has used to define these categories is the Macaulay Duration of the underlying portfolio. (jargon alert)
No, no, don’t start scratching your head. Let’s try and make sense of this.
The Macaulay Duration (or simply called as Duration) is a measure of the no. of years the instrument will take to return the investment. The interest rate is used as an input to calculate the Duration.
You may have also heard about Modified Duration, which is more popularly used and is a modified version of the Macaulay Duration. The Modified Duration measures the sensitivity of the debt fund to the interest rate or a measure of the interest rate risk. It is also expressed in number of years.
As is now known, there is an inverse relationship between interest rates and price of a debt instrument.
Take for example, a debt fund, which has a Modified Duration of 4.7 years. It means that if the interest rates increase by 1%, the price of the debt instrument will fall by 4.7%. The vice versa is also true.
This numbers gives you an insight on the riskiness of the fund with respect to change in interest rates. Higher the duration, more interest rate risk the investment carries.
Hopefully, now you have a basic working idea of this concept.
So, SEBI has used the Duration along with Maturity and investment credit ratings to define the categories of the debt funds.
Here are the new categories and how they are different.
Duration based fund categories
We went through the concept of duration above. Based on this parameter, the funds have investment in Debt and Money market instruments with different duration profiles.
- Ultra Short Duration Fund – Duration of the portfolio between 3 to 6 months.
- Low Duration Fund – Duration of the portfolio between 6 to 12 months.
- Short Duration Fund – Duration of the portfolio between 1 to 3 years.
- Medium Duration Fund – Duration of the portfolio between 3 to 4 years.
- Medium to Long Duration Fund – Duration of the portfolio between 4 to 7 years.
- Long Duration Fund – Duration of the portfolio greater than 7 years.
- Dynamic Bond – Investment across duration; you may call it a diversified debt fund.
- Gilt Fund with 10 year Constant Duration – Minimum 80% investment in GSecs or Government securities to maintain a 10 year Duration of the portfolio.
As you would notice, the current categories of Ultra short term, Short term, Medium and Long term have been further fine tuned with clear definitions with reference to duration.
If you have understood the concept of duration, you can now pick and choose a fund that is most relevant for your portfolio and goals.
Maturity based fund categories
Maturity simply means the how much time is left before you the issuer repays the original investment to you.
In contrast, duration, as discussed before, is a measure of sensitivity to change in interest rates.
The maturity based funds include:
- Overnight Fund – Investment in securities that mature in 1 day or overnight.
- Liquid Fund – Investment in securities that mature in upto 91 days.
- Money Market Fund – Investment in securities having maturity upto 1 year.
- Gilt Fund – Minimum 80% investment in G-Secs or Government securities across maturity.
Ratings based fund categories
Credit rating companies assign ratings to the financial instruments used by various organisations based on their financial health, ability to repay, etc. Some of the usual credit agency names are CRISIL, ICRA, Brickworks, etc.
Credit rating, as you have guessed by now, is an indicator of the health of a company to be able to make timely payments on the loans it takes and is used by financial institutions to assess if to lend or not. Simply, think of it like your personal credit score, just that the rating is for a business or an instrument. Know more here.
The rating ladder typically has AAA/AA+ (highest rating) at the top and moves to Junk / Default (lowest rating) to the bottom. The actual words can vary by credit rating agency.
Based specifically on the ratings parameter, there will be 2 types of funds:
- Corporate Bond Fund – Minimum 80% investment in corporate bonds with AA+ or above rating
- Credit Risk Fund – Minimum 65% investment in corporate bonds with AA or below rating
Of course, when you invest in lower credit rated investments, you take on credit risk – the other risk in debt instruments, apart from interest rate risk. For all debt funds, you must look at their credit rating profile. It is available on the fund factsheets.
- Banking and PSU Fund – Minimum 80% investment in bonds issued by Public sector banks, PSUs, Public Financial Institutions and Municipalities.
- Floater Fund – Minimum 65% investment in floating rate instruments.
A floating rate fund adjusts its interest payouts with changes in rates and thus has less of an impact due to change in interest rates.
How does it impact you?
If you are already an investor in a debt mutual fund scheme, you will want to revaluate if the scheme continues to make sense for your goals or not.
Most investors care only look at past returns to select a fund. They do not pay attention to the risk. Hopefully, the new categorisation will enable to better understand the risk aspects too of a debt fund.
Currently, the fund houses are working on the reclassification and changing any characteristics of the schemes. Some have announced the changes. Take for example, this DSPBR Money Manager fund.
In due course, most mutual funds will start sharing the revisions with you. You can keep a watch on your inbox or visit Unovest for the updates, as they roll out.
Ok, all this is fine. But how do I put this into perspective?
While I understand Is there a way to select a fund based on whether I just want to set aside some money safely, or also seek some growth or purely target some appreciation. Can I sort further on the basis of risk and the time I want to invest for?
Surely, handling 16 categories is not easy. While there is more clarity on what each of the debt fund category has to offer, as an investor you still need to make a choice. How to do that?
In the follow up post, we will see how you can put your finger on the debt fund that you need.
Till then let your questions flow.
Note: The sub categories of Duration, Maturity, Credit Ratings and Others have been done by Unovest. SEBI has clustered all the 16 categories under Debt funds.