Banking and PSU Debt Funds: Good fixed income investment options in current environment

Over the past few years, we have seen growing interest in debt mutual funds among retail investors visiting our website. AMFI data shows that retail and HNI investors now have 46% share of debt mutual fund (excluding liquid and money market) assets under management (AUM), significantly higher than what their share was 4 – 5 years back. However, credit risk related events over the last 9 – 10 months in the debt market starting with the ILFS default last September have certainly dented investor confidence in debt mutual funds. Several financial advisors have shared with us concerns about their client’s credit risk exposures and are hesitant recommending debt mutual funds for their clients.

In this blog post, we will discuss why debt mutual funds continue to be good investment options and one particular debt fund category, Banking and PSU Debt Funds which can provide good returns with limited risks in the current environment.

Why debt mutual funds continue to be good investment options?

Though awareness of debt mutual funds is still fairly limited among retail investors in India, over the last few years informed investors have seen debt funds as relatively safe savings and investment options, with the potential of providing superior tax efficient returns compared to traditional fixed income investment options like Post Office small savings schemes, Bank Fixed Deposits and corporate / NBFC Fixed Deposits. Though the credit downgrades and defaults have affected returns of some debt schemes, we think debt mutual funds continue to be good investment options for the following reasons:

• Debt mutual funds invest in fixed income securities which provide superior yields than risk free investment interest rates (post office savings schemes, bank FDs) over comparable investment tenures
• Debt mutual funds offer a bouquet of products suitable for different investment tenures (very short term, short term, medium term and long term), risk appetites and investment needs.
• In the last 1 year, several debt fund categories delivered superior average returns compared to Bank FDs despite the credit concerns.
• The RBI has already cut benchmark rates thrice by cumulative 75 basis points since the start of this year. The Government cut small savings interest rates by 10 basis points a few weeks back and banks are expected to follow suit by reducing FD interest rates. Government bond yields are expected to soften further and further cuts in post office small savings / bank FD rates are on the anvil. Debt funds of high credit quality, on the other hand, will benefit from softening yields and are likely to give superior returns to investors in the current interest rate regime.
• Debt fund investments over longer investment tenures (3 years or more) are much more tax efficient than traditional fixed income investments. While most traditional fixed income interest is taxed as per the tax rate of the investors, debt fund capital gains are taxed at 20% after allowing for indexation benefits. Long term capital gains tax rate (including indexation benefits) make debt mutual funds much more tax efficient for long term investors in higher tax brackets compared to traditional fixed income investments

Credit risk related concerns and investment options

While many of our regular readers are aware of the benefits of investing in debt mutual funds, credit risk is an overarching concern for many debt fund investors now, good returns notwithstanding. We do not know when we will get the next bad news. Furthermore,this situation may take some time to get resolved. The background factors causing credit risk issues and resolution of these issues are beyond the scope of this particular post, but it suffices to say that it will continue to be a concern in the near term. As such, in the present environment, debt funds with substantially lower credit risk are suitable investment options for conservative or moderately conservative investors. Banking and PSU debt funds are good medium to long term investment options (2 – 3 years or more) for conservative to moderately conservative investors in the current environment.

What are Banking and PSU debt funds?

This is a new category of debt mutual fund schemes defined by SEBI in their mutual fund re-classification circular issued in October 2017. As the name suggests, these funds mostly invest in a mix of bonds or debentures issued by banking firms and public sector enterprises including public financial institutions. SEBI mandates these funds to invest 80% of their assets in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions.

Superior Credit Quality

The underlying securities of Banking and PSU debt funds ensure superior credit quality. Since most PSUs issuing bonds or debentures are owned by Government of India, they usually enjoy the highest credit rating. Irrespective of their financial performance, Government ownership of PSUs provides a degree of assurance with regards to interest and principal payment. These funds also invest in certificates of deposits and bonds issued by public sector and private sector banks. Like PSU bonds or debentures, debt and money market securities issued by banks also enjoy high credit ratings. Scale of operations, capitalization and borrowing ability of banks compared to NBFCs, ensures superior high credit rating of bank CDs and bonds. Since 80% of the assets in Banking and PSU debt funds are invested in highly rated securities, these funds are one of the safest investment options among debt funds. Though there are no restrictions on balance 20% of the scheme portfolio, most Banking and PSU debt funds have veered towards Government securities instead of lower rated securities. These funds are therefore, excellent choices for conservative or moderately conservative investors.

Superior Liquidity

Banking and PSU debt securities are well traded in the secondary market and offering high liquidity to investors of Banking and PSU debt fund schemes. High liquidity of these securities in secondary market also offer fund managers to position their portfolio duration (switching between short duration and long duration bonds) to capitalize on price movements in different interest rate scenarios.

Good potential returns

Yields have been softening for the last year or so and longer duration debt funds have given superior returns . Banking and PSU debt funds have repositioned their duration profile from short duration to medium duration to take advantage of price movement from declining yields. In the last 12 months, Banking and PSU debt funds have given 9.76% average returns. In the last 3 months these funds have given 3.08% returns. The strong performance of these funds is expected to continue in the near to medium term in the current interest rate regime.

The RBI has changed its monetary policy to “accommodative” in the last monetary policy meeting signalling lower interest rates and the Government’s commitment to fiscal consolidation in the Budget has provided room for more rate cuts in the future. The interest rate actions of US Federal Reserve impacts global fund flows and bond yields globally. The US President, Donald Trump has been pushing for lower interest rates and recent statements by Federal Reserve Chairman, Jerome Powell seems to re-affirm the rate cut view. This will be a positive for the bond market globally, including India. Bond yields are expected to soften further and debt funds like Banking and PSU debt funds are likely to give good returns.

Conclusion

In this blog post, we discussed why Banking and PSU debt funds are good investment options for conservative to moderately conservative debt funds. The short to medium duration profiles of these funds limits interest rate risk. Conservative investors should select shorter duration Banking and PSU debt fund schemes to further reduce interest rate risk. If you have appetite for some interest rate risk and a sufficiently long investment horizon (3 – 4 years), you can invest in slightly longer duration Banking and PSU debt funds. Most importantly, these funds have very low credit risks and can be excellent investment options for investors looking for stable returns. Investors should consult with their financial advisors, if Banking and PSU debt funds are suitable for their financial needs.