Put 70% of fixed income portfolio in high credit quality shorter-duration funds
What are duration funds and how much money can be invested in such funds and for what period?
A fixed-income investor should allocate exposure to different debt fund categories (short-term debt, medium and/long-term debt, and credit) based on his recommended asset allocation, which in turn is dependent on his risk appetite. Shorter duration funds (Short duration, BPSU, Corporate Bond, etc.) provide accrual yield and subject investors to relatively lower market-to-market risk. Longer duration funds (medium-to-long, long duration, etc.) offer a higher yield compensating investors for the maturity (duration) risk, and present an opportunity for significant capital appreciation in a falling interest-rate cycle.
However, these would deliver subdued performance in case interest rates move north. Funds taking exposure to corporate securities offer additional yield to compensate investors for taking on credit risk.
Investors should ideally follow a core-satellite approach, with the core (70%) of the portfolio invested into high credit quality (safer) shorter-duration funds to minimise credit and duration risks, while the satellite portion of the portfolio can be allocated to longer-duration and credit-risk funds. Investors taking tactical calls based on their expectations on the various segments of the yield curve, may allocate higher exposure to the non-core segment of the portfolio.
Fixed-income funds too are prone to the risk of capital loss, as has been evident from the recent market events over the past two-three years, which saw signifi-cant markdowns in several debt funds following downgrades and defaults of various issuers. Diversify holdings across two or more funds and/ or fund-houses to avoid concentration to the interest rate / credit related calls of a fund manager / fund-house.
To benefit from favourable taxation compared to bank FDs, investors should look to invest for holding periods over three years. For holding periods of over three years, the gains are taxed at 20% (excluding cess and surcharge) post indexation of costs, unlike at the marginal tax rate in case of FDs. For shorter holding periods, (up to three years), the gains are added to income and taxed at the marginal tax rate.
The writer is director, Investment Advisory, Morningstar Investment Adviser (India). Send your queries to firstname.lastname@example.org