Funds will stick to duration norms, but may take credit risk

Illustration by Ajay Mohanty
In the recent re-categorisation of schemes that fund houses have undertaken in response to the Securities and Exchange Board of India’s (Sebi’s) October circular, many debt and hybrid funds have been shuffled around. Investors need to understand the change that has happened in the funds they hold and only then decide whether to stay put or exit and move to another fund. Among debt funds, a large number of categories, 16, have been created. In the very short-duration segment, only liquid funds existed earlier, which invested in papers with a maturity of up to 91 days. Now, two new categories have been introduced. One is overnight funds, which will invest in papers with a maturity of one day only. “This category is meant for institutional investors. Retail investors can give it a miss,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. Another low-duration category that has been introduced is money market funds, which will invest in certificates of deposit and commercial papers. 

The way erstwhile income funds are managed is set to change. Now, these funds will have to operate within a fixed-duration band. Medium-duration funds will have an average portfolio duration of three-four years, while medium- to long-duration funds will have an average duration of four-seven years. “In a rising rate scenario, if the fund manager wants to reduce his duration, he will have to take special permission from his board to do so,” says Belapurkar. Longer duration funds, which now need to maintain an average portfolio duration of above seven years, could decline sharply if rates rise, a risk that retail investors need to be aware of. 

Watch the newly formed corporate bond fund category. Here, at least 80 per cent of the portfolio must be invested in double A-plus papers. Funds moving into this category may see considerable changes in their strategies. “A credit opportunity fund moving into this category will have to bring down its credit risk, while a dynamic bond fund will have to stop taking duration risk and move to an accrual strategy,” says Bhavana Acharya, deputy head-mutual fund research, Franklin India Income Builder, which was earlier a credit opportunity fund, will now become a corporate bond fund.

Investors will have to watch the portfolios of their debt funds closely to understand their risks. Earlier, in the short-term debt category, some funds took credit risk and others didn’t. This issue will persist. “Just because Sebi has said that short-duration funds should have an average portfolio duration of one-three years does not mean that they will not take credit risk. Investors will have to understand the risks in a portfolio instead of choosing a fund based only on past returns,” says Acharya. 

In the hybrid segment, a category called balanced hybrid has been created, which will take 40-60 per cent equity exposure. This category may not find too many takers. Most balanced funds of the past have shifted to the aggressive hybrid category, where the equity exposure is 65-80 per cent, as this will make them eligible for equity-like tax treatment.

Another new category called dynamic asset allocation or balanced advantage funds has been created. It is akin to the multi-cap category of equity funds. It is the go-anywhere category among debt funds where fund managers will be free to take any kind of exposure. HDFC Prudence, earlier a balanced fund, has been reclassified into this category. Investors need to watch if the equity exposure of this fund, currently above 70 per cent, changes (this is unlikely).  

Avoid a hasty exit from a fund whose category has changed. Allow the new portfolios to be formed, and exit a quarter or two from now, if the portfolio has changed drastically, and the fund no longer serves your need.