passive debt funds in india: features & strategies
TRANSCRIPT
Passive Debt Funds in India: Features & Strategies
An iFAST Research Report | August 2021
Krishna Karwa
Senior Research Analyst, iFAST Financial India Pvt Ltd
iFAST Financial India Pvt Ltd Proprietary 1
Preface
Passive investing has been making rapid inroads in India's mutual fund industry with growing
awareness of low-cost investment products. While the equity based passive products are well-
discovered and reasonably understood by now, passive debt products have been comparatively slow
to enter the market. This is understandable, since fixed income investment returns require complex
and dynamic calculations, unlike returns on equity investments that have a linear relationship with
market movements.
AMCs have risen to the challenge, and in the last year and a half , we have seen a spate of debt-based
exchange traded funds (ETFs) and index funds being launched. The passive debt products we now
have in India have clearly differentiated attributes versus the actively managed funds. Upon study, we
realised that these differences make passive debt funds a valuable tool for financial planners,
distributors and advisory practitioners.
In this report, we study the landscape of the available debt mutual funds* by segregating them into
the following three groups:
Passive debt funds with predefined maturity
Passive funds with no predefined maturity
Active debt funds
Apart from studying the defining attributes of each category, we offer guidance on suitability for
investors, as well as important caveats to bear in mind when selecting each.
We hope the insights prove fruitful. Happy investing!
* This report addresses open-ended funds only. Fixed Maturity Plans (FMPs) are an entirely different product and are not
part of the comparison.
iFAST Financial India Pvt Ltd Proprietary 2
Glossary
Term Abbreviation
AMC Asset Management Company
CDL Central Development Loan
CPSE Central Public Sector Enterprise
FD Fixed Deposit
G-Sec Government Securities
MF Mutual Fund
PSU Public Sector Undertaking
RBI Reserve Bank of India
SDL State Development Loan
SIP Systematic Investment Plan
STP Systematic Transfer Plan
SWP Systematic Withdrawal Plan
YTM Yield to Maturity (also referred to as ‘yield’)
iFAST Financial India Pvt Ltd Proprietary 3
Contents
Landscape of Debt Mutual Funds in India ....................................................................................... 4
Key Attributes of Passive Debt Funds ............................................................................................. 5
Investment horizon ................................................................................................................... 5
Return profile ........................................................................................................................... 6
Interest rate risk ....................................................................................................................... 6
Credit risk/G-sec exposure risk .................................................................................................. 6
Transactional attributes ............................................................................................................ 6
Positioning Debt in Portfolios ........................................................................................................ 8
Passive debt funds with predefined maturities ........................................................................... 8
Passive debt funds without predefined maturity......................................................................... 8
Active debt funds...................................................................................................................... 9
Debt funds as per risk profile ................................................................................................... 11
Conclusion ................................................................................................................................. 11
iFAST Financial India Pvt Ltd Proprietary 4
Landscape of Debt Mutual Funds in India
The following table presents the debt mutual funds available in India at the time of writing this report.
Active open-ended debt funds are too many to enumerate, so only the categories have been listed.
Table 1: Debt Mutual Funds Available in India
Investment Horizon
Duration Passive Debt Funds (Predefined Maturity)
Passive Debt Funds (No Predefined Maturity)
Active Debt Funds (Categories)
Temporary < 6 months - Nippon India ETF Liquid
Bees
- Overnight
- Liquid
- Ultra Short Term
Short Term 6-12 months
- - - Low Duration
- Money Market
Short to
Medium Term
1 – 3 years - Bharat Bond ETF 2023 - - Short Duration
- Nippon India ETF Nifty CPSE Bond Plus SDL – 2024
- Floater
Medium Term 2 – 5 years - Bharat Bond ETF – April
2025
- Motilal Oswal 5-Year G-
Sec ETF
- Corporate Bond
- Nippon India ETF SDL Nifty SDL – 2026
- Nippon India ETF 5-Year Gilt
- Banking & PSU
- Axis AAA Bond Plus SDL
ETF – 2026
- Medium Duration
- Edelweiss Nifty PSU Bond Plus SDL Index Fund – 2026
- Credit Risk
Medium to
Long Term
5 – 7 Years - IDFC Gilt 2027 Index
Fund
- - Dynamic Bond
- IDFC Gilt 2028 Index Fund
- Medium to Long Duration
Long Term > 7 Years - Bharat Bond ETF - April 2030
- LIC MF G-Sec Long Term ETF
- Long Duration
- Bharat Bond ETF – April 2031
- Nippon India ETF Long Term Gilt
- G-Sec
- SBI ETF 10-Year Gilt - G-Sec with 10-
Year Fixed Maturity
iFAST Compilations | Data as on August 23, 2021
iFAST Financial India Pvt Ltd Proprietary 5
Key Attributes of Passive Debt Funds
Passive debt funds, comprising exchange traded funds (ETFs) and index funds, replicate an underlying
debt benchmark and thus offer returns approximating it. In doing so, they have to comply with the
following SEBI norms1 for passive debt funds:
(a) The constituents of the index shall be aggregated at issuer level.
(b) The index shall have a minimum of 8 issuers.
(c) No single issuer shall have more than 15% weight in the index.
(d) The rating of the constituents of the index shall be investment
grade.
(e) The constituents of the index shall have a defined credit rating
and defined maturity as specified in the index methodology.
The norms are reassuring from an investor protection point of
view, as they define the permissible concentration and credit risk
of the underlying investments of passive funds.
Interestingly, while the guidelines allow passive debt funds to
choose from among all investment grade products, the currently available passive debt funds primarily
pertain to bonds issued by central and state governments, public sector undertakings and AAA rated
private corporations. With this, asset management companies (AMCs) are taking a clear direction in
terms of minimising credit risk in passive debt funds, which is an important indicator of the products’
suitability.
Let’s delve further into other key attributes of passive debt funds, and what they mean for investors.
Investment horizon
At this point, most of the passive debt funds are available for medium and long term periods . This
seems to be geared towards encouraging investors to hold units for at least three years and derive
taxation benefits.
In comparison, active debt funds are available for the full range of tenures, from one day to over 10
years. This allows for a more customised approach for investors, who can choose from across several
categories depending on the maturity profile they want in their portfolio.
1 https://www.sebi.gov.in/legal/circulars/nov-2019/norms-for-debt-exchange-traded-funds-etfs-index-funds_45146.html
Asset Management
Companies are taking
a clear direction in
terms of minimising
credit risk in passive
debt products. This is
an important
indicator of the
products’ suitability
for investors.
iFAST Financial India Pvt Ltd Proprietary 6
Return profile
Passive debt funds with predefined maturity are an interesting product for investors, as the tentative
yield to maturity (YTM) is known at the time of investment. Assuming they stay invested till maturity,
investors can lock their investments at a certain yield at the point of investment.
Passive debt funds with no predefined maturity and active debt funds tend to witness changes in yields
depending on how prices of underlying debt instruments change
over a period of time.
Interest rate risk
In case of passive funds with predefined maturity, there is no
interest rate risk if units are held till maturity. However, if the
investor sells before maturity, the NAV of the fund will be
determined by the prevailing NAVs of the underlying debt securities
at the time, and it can be higher or lower than the investor’s entry
price. Passive funds with no predefined maturity and active debt
MFs investing in medium to long term debt instruments are
sensitive to interest rate movements, and thus have volatile NAVs in response to interest rate cuts or
hikes by the Reserve Bank of India (RBI).
Interest rate sensitivity is an important attribute currently, since the RBI wil l have to step in at some
point to tackle inflation and prevent overheating in the economy. If inflation remains persistently high
above the central bank’s upper band of 4 percent, a hike in the repo rate is certain eventually.
Credit risk/G-sec exposure risk
As discussed, passive debt funds currently carry minimal credit risk since the issuers of debt are
primarily governments or government-backed enterprises. In contrast, active debt funds are
vulnerable to defaults to the extent of exposure to private sector corporate bonds.
However, it is worthwhile noting that even funds with higher exposure to government securities are
vulnerable to price changes. In instances of revenue shortfall, central and state governments may be
forced to borrow more than what the debt markets anticipate. This will lead to a higher supply of G-
Secs in the market, in turn causing the NAVs of passive and active debt funds that invest heavily in
them, to decline.
Transactional attributes
Expense ratios of passive debt funds are lower than those of active debt funds since there is no need
to manage duration and credit quality. Active debt funds have the flexibility to alter their portfolio,
subject to guidelines defined by SEBI and the AMC's framework. As a result, their expense ratios tend
to be higher.
Assuming they stay
invested till the end,
investors can lock
their investments at a
certain yield in
passive debt funds
with predefined
maturity.
iFAST Financial India Pvt Ltd Proprietary 7
In passive debt funds, investments/redemptions are undertaken based on day-end NAVs (in index
funds) or real-time NAVs on the exchange (in ETFs). For active funds, investments/redemptions are
undertaken based on day-end NAVs.
In the context of passive debt funds, investments through SIPs can be undertaken only in index funds,
whereas a demat account is mandatory for ETF transactions. In active funds, investors can invest
through SIPs and lumpsums, and a demat account is not mandatory.
iFAST Financial India Pvt Ltd Proprietary 8
Positioning Debt in Portfolios
Across all debt funds, we recommend investing primarily at the shorter and medium end of the
duration curve currently, given the heightened interest rate risk. While short term funds can help limit
volatility, medium term options offers a good risk-return trade-off if the units are held on for at least
3 years (from a taxation perspective).
Investing at the longer end of the duration curve is only ideal after interest rates have moved up.
We now look at specific recommendations for the three categories of debt mutual funds.
Passive debt funds with predefined maturities
These are best suited to risk-averse investors seeking predictable return over the medium to long
term. For instance, individuals who a) are likely to hold on till maturity, and b) do not wish to encounter
uncertainty in expected return in their portfolios, can look at this category.
If a debt fund has meaningful exposure to credit risk, duration being similar, its yields should be higher
than funds with lower credit risk. At this juncture, our three preferred passive debt funds with
predefined maturities have lower credit risk and yet their yields are higher than funds with
comparatively higher credit risk and exposure to corporate bonds. Therefore, they present very
attractive investment options for investors to consider.
Table 2: Recommended passive debt funds with predefined maturity
Investment horizon
Fund TER Parameters as on July 31, 2021 (For July 2021)
Yield to maturity
Average maturity
Modified duration
(%) (Years)
Short to medium term
- Bharat Bond ETF - April 2023 0.0005 4.53 1.67 1.52
(1 - 3 years ) - Nippon India ETF Nifty CPSE Bond Plus SDL - 2024 Maturi ty
0.15 5.28 2.98 2.57
Medium term - Bharat Bond ETF - April 2025 0.0005 5.64 3.57 3.05 (3 - 5 years ) - Nippon India ETF Nifty SDL - 2026
Maturi ty 0.15 6.13 4.49 3.67
- Axis AAA Bond Plus SDL ETF - 2026 Maturi ty
0.15 5.90 4.22 3.46
- Edelweiss Nifty PSU Bond Plus SDL Index Fund - 2026 Maturi ty
0.31 6.08 4.54 3.73
Modified duration represents the degree of interest rate risk. Higher the number, higher the risk. Source: iFAST Compilations
Passive debt funds without predefined maturity
Without a defined maturity, these funds carry high interest rate risk currently and should be looked
at only by risk-taking investors with a medium to long horizon. It’s best to consider investing in such
iFAST Financial India Pvt Ltd Proprietary 9
funds after a rate hike cycle has begun since there is no scope to tweak the maturity of debt
instruments in the portfolio.
To elaborate, an investor with a 5-year horizon can look at a 5-year G-Sec ETF (no index fund option
available in this category). Return at the end of 5 years will be contingent on how the interest rate
cycle and the central government’s borrowing plan pans out during this period. Yields (and therefore
return prospects) will keep changing over a period of time.
Table 3: Recommended passive debt funds without predefined maturity
Investment horizon
Fund TER Parameters as on July 31, 2021 (For July
2021)
Yield to
maturity
Average
maturity
Modified
duration (%) (Years)
Medium term Nippon India ETF 5 Year Gi l t
0.09 5.68 4.59 3.91
Modified duration represents the degree of interest rate risk. Higher the number, higher the risk. Source: iFAST Compilations
In the current scenario, investors looking to manage duration (and interest rate risk) can therefore
consider active funds instead.
Active debt funds
Exposure to this category can be highly customised after considering an inve stor’s investment horizon
and tolerance to credit/interest rate risks. This makes them worthwhile for any investor. For example,
investors can choose from funds with average maturities of 1 day (overnight funds) to over 10 years
(long duration funds). Those who don’t wish to take credit risk can choose categories/funds that
predominantly invest in high credit rated debt instruments.
Unlike passive funds with a predefined maturity, yields (and return prospects) of active debt funds
may move up or down depending on conditions prevailing in the debt market. Only investors who can
bear volatility in NAVs during the course of their investment horizon should consider active funds.
In comparison to passive funds with no predefined maturity, active funds have an e dge at this juncture
owing to the flexibility of the fund manager to manage duration (as per SEBI’s stipulated guidelines).
This, in turn, will help limit interest rate risk.
Our recommended funds across categories are as follows:
Table 4: Recommended active debt funds
Investment
horizon
Category Fund TER Parameters as on July 31, 2021
(For July 2021)
Yield to maturity
Average maturity
Modified duration
(%) (Years) Short term (Up to 1 year)
Liquid (Up to 3 months)
- Axis Liquid Fund 0.25 3.50 0.09 0.08 - Aditya Birla Sun Li fe
Liquid Fund
0.33 3.60 0.09 0.09
Ultra short duration
(3 - 6 months)
- HDFC Ultra Short Term
Fund
0.64 3.92 0.48 0.45
iFAST Financial India Pvt Ltd Proprietary 10
Investment horizon
Category Fund TER Parameters as on July 31, 2021
(For July 2021)
Yield to maturity
Average maturity
Modified duration
(%) (Years)
- SBI Magnum Ultra Short Duration Fund
0.49 3.69 0.46 0.32
Low duration (6
months - 1 year)
- Kotak Low Duration
Fund
1.18 4.51 1.77 0.84
- Axis Treasury Advantage Fund
0.61 4.16 0.91 0.68
Short to medium
term (1 - 3 years )
Short duration - HDFC Short Term Debt Fund
0.79 5.08 2.95 2.13
- IDFC Bond Fund - Short Term Pl an
0.77 4.65 2.14 1.86
Floating rate IDFC Floating Rate Fund 0.75 4.03 1.07 0.68 Medium term (3 - 5 years )
Corporate bond - Kotak Corporate Bond Fund
0.66 5.11 2.63 1.58
- HDFC Corporate Bond Fund
0.61 5.32 4.16 2.68
Banking & PSU - Kotak Banking & PSU Debt Fund
0.77 5.61 4.70 2.57
- Nippon India Banking &
PSU Debt Fund
0.79 5.08 3.16 2.37
Medium duration - SBI Magnum Medium
Duration Fund
1.21 5.49 2.77 1.81
- HDFC Medium Term
Debt Fund
1.30 6.38 4.02 3.00
Credit ri sk ICICI Prudential Credit Risk Fund
1.57 7.07 2.68 1.92
Modified duration represents the degree of interest rate risk. Higher the number, higher the risk.
Source: iFAST Compilations
Investments in liquid (3 months) and ultra-short duration funds (3-6 months) are low-risk, low-yield in
nature and should be used to park funds temporarily or to initiate STPs/SWPs. Since low duration
funds (up to 1 year) invest for a relatively longer period, yields are slightly higher.
Those who wish to bridge the gap between short and medium term investing can look at short
duration and floating rate funds. As per SEBI’s mandate, short duration funds must ensure that the
Macaulay duration (represents the weighted average time period to receive all cash flows from all
debt instruments) of the portfolio is between 1 and 3 years, whereas floating rate funds are
advantageous at a time when interest rates are slated to move up.
In the medium term basket, some degree of interest rate risk is a given. The focus should therefore be
on minimising credit risk in order to limit volatility in NAVs. We recommend prioritising corporate
bond funds and banking & PSU debt funds owing to their exposure in high-rated debt instruments.
Investors who wish to derive better yields, albeit with some degree of credit risk, can consider medium
duration funds, where the Macaulay duration, as per SEBI’s mandate, ought to be between 3 and 4
years and there is no regulation regarding the credit quality of the debt instruments.
As per SEBI’s definition, credit risk funds are required to invest minimum 65 percent of the portfolio
in debt instruments that are not the highest rated in terms of credit quality. Though yields can be high
despite a shorter maturity profile, this category is extremely vulnerable to adverse dynamics in the
debt markets. This is particularly true in cases where marquee names default and/or liquidity risk for
iFAST Financial India Pvt Ltd Proprietary 11
low-rated debt instruments spikes. Only investors with a high appetite for risk should consider this
category.
Debt funds as per risk profile
Risk profile Passive debt funds Active debt funds
Predefined maturity No predefined maturity
Conservative
Moderately conservative
Balanced
Moderately aggressive
Aggressive
Source: iFAST Compilations
Conclusion
Given that interest rates are expected to rise over the next two years, we recommend that risk -averse
investors consider passive debt funds with predefined maturities as they offer certainty of returns
when held to maturity. As on today, for a similar duration, their yields are higher than those of passive
debt funds without predefined maturities.
In times of high inflation, debt funds are vulnerable to negative real returns. We expect the short to
medium term inflation rate to be in the range of 5–5.5 percent. To derive yields higher than this mark,
some degree of credit risk (by way of exposure to debt instruments other than G-Secs, quasi G-Secs
and AAA corporate bonds) and/or interest rate risk (by investing in debt instruments with medium
and long term maturities) will therefore have to be taken in one’s core portfolio.
Furthermore, when putting in place an asset allocation framework, investors’ exposure to debt funds
should be complemented with exposure to domestic and global equities in accordance with their risk
profile.
iFAST Financial India Pvt Ltd Proprietary 12
Disclaimer
iFAST and/or its content and research team's l icensed representatives may own or have positions in the mutual
funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to
time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or
solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken
without first viewing a mutual fund's scheme information document including statement of additional
information. Any advice herein is made on a general basis and does not take into account the specific investment
objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and
legal advice before making an investment or any other decision. Past performance and any forecast is not
necessarily indicative of the future or l ikely performance of the mutual fund. Opinions expressed herein are
subject to change without notice.