How do I build my debt portfolio?

Let’s first start with all the debt instruments you can invest in:

· Savings Account

· Fixed Deposit

· Employee Provident Fund

· Public Provident Fund

· Post Office Deposits such as National Savings Certificates

· National Pension Scheme

· LIC Endowment Plans

· Debt Mutual Funds

Savings account, FD, PF, NSC, NPS, LIC schemes are very well known and popular in India. Hence, this article will focus on debt mutual funds, which is also my preferred category to build bulk of my debt portfolio.

At this point, you might think what the need of debt mutual funds is when we can invest in EPF, PPF, and Fixed Deposits. For FDs answer is straightforward. They are not tax efficient and interest rates are going to get worse in future.

Now coming to the PPF, they can only be used for 15 year+ goals and cannot be redeemed for other short-mid term goals. Similar issues with EPF. Also, you need to rebalance your portfolio (let’s say annually) to get the optimum risk adjusted returns. With PPF and EPF this annual rebalancing is not feasible, justifying the space for debt mutual funds in your portfolio.

Now we are convinced with the importance of debt mutual funds, let’s look at the key factors to consider while selecting the debt mutual funds:

· Duration: Depending on the time duration, there are various debt funds such as liquid funds (less than 3 months) , ultra-short duration fund (3 months- 1 year), short duration fund (1–3 years), medium duration (3–5 years), long duration fund (5+ years).

· Risk: There are 2 main types of risk with debt mutual funds:

o Interest rate risk: Without going into detail, just note that value of debt fund is inversely proportional to the interest rate. When interest rate rises, debt fund goes down in value and vice versa. You can link it to the different duration bonds discussed above. Longer the duration of bond, more exposed it is to the interest rate risk.

o Credit risk: Companies are assessed based on their debt repayment capability and assigned a credit rating (AAA, AA, BBB, BB, and so on). Lower the credit rating of a company, higher the risk of default.

Looking at duration, interest rate risk, and credit risk together, we can divide the debt mutual funds in 3 categories:

1. Category 1: This is the debt category with shortest duration and negligible interest rate and credit risk. Liquid funds, overnight funds fall into this category. Focus is on safety and liquidity, resulting in lower return as well (returns equal to or slightly better than bank savings account)

2. Category 2: This is the debt category with short-medium duration and low interest rate and credit risk. Low duration, short term, corporate bond, banking and PSU funds fall into this category. Focus is on taking some credit and interest rate risk without compromising much on safety, resulting in slightly higher return as well (returns slightly better than bank fixed deposits)

3. Category 3: This is the debt category with medium-long duration and high interest rate and credit risk. Dynamic Bond, Credit risk, Debt oriented hybrid funds fall into this category. Focus is on generating high returns by taking varying degree of credit and interest rate risk (returns significantly better than bank fixed deposits)

In conclusion, it’s important to think about your risk appetite, time horizon, and objective of including debt in your investment portfolio. For example, role of debt in my portfolio is to provide stability and not generate high returns (that is the role of equity). Hence, I focus on category 1 (to park any excess money or money required for very short-term goals) and category 2 (for any other short-medium term goals) to build my debt portfolio.