Mutual Funds: Which debt fund categories are best for long-term goals?

First things first, people may have different definitions of long-term goals. But for the sake of our discussion, we will assume that long-term goals here are 7-10 years away (or even longer).

Most people who plan to invest for such long-term goals, would want to know which are the equity funds to pick. Then why am I talking about debt fund categories here?

There are a few reasons for that. Not everyone is suited for a 100% equity portfolio. Also, when you understand the true benefits of asset allocation, you will agree that even for long-term goals, having some debt allocation is a wise thing. In such asset-allocated long-term portfolios, debt funds also allow us to carry out rebalancing efficiently in a periodic manner.

And you may ask now why not just use bank FDs which not only offer high interest rates currently, but have similar taxation to debt funds.

Note: Debt funds earlier had indexation benefits and lower taxes. But now since March 2023, the capital gains from debt funds are taxed as per investor’s tax slab.

The reason why FDs aren’t the best choice here is that FD is taxed every year. But unlike fixed deposits, the debt funds are not taxed each year and are taxed only when you redeem after years. So, it allows you to defer taxation to a later date.

That I think establishes pretty much the need for debt (even if it’s a small allocation) in the long-term portfolios.

Now comes the question, as to where to invest this debt portion.

My strong suggestion is to first try and exhaust all the sovereign, tax-free, debt options first. These are EPF (+VPF), PPF, Sukanya Samriddhi Yojana, etc. Once you have used these, only then look for suitable debt fund categories. Generally, this will happen when your portfolio size has grown large and the upper limits of EPF/PPF/Sukanya, etc. now don’t allow you to contribute anymore.

So now we look at the debt fund categories suitable for debt allocation of your long-term goals.

Here are a few categories that can be considered -

• Short Duration Debt Funds– This debt fund category invests primarily in bonds/papers that are maturing in a period of 1-3 years.
• Dynamic Bond Debt Funds– This category and their fund managers have the freedom to invest in bonds/papers of any duration (from a few months to several years) depending on where the fund manager expects to earn good returns.
• Banking & PSU Debt Funds - These invest primarily in bonds/papers issued by banks, PSUs, and public financial institutions.

And for those investors who have a higher risk appetite and are also willing to consider higher volatility in the short term and/or are willing to take a bit more risk can consider these additional categories as well:

• Corporate Bond Debt Funds - These types of debt funds invest primarily in high-grade corporate bonds/papers issued primarily by private entities.
• Gilt/Constant Maturity Debt Funds- These debt fund categories invest mainly in instruments issued by the government across periods and primarily in government instruments across periods such that average maturity is constantly maintained around 10 years respectively. Since these are sort of government-backed, there is no risk of default. But in the short term, these funds can undergo sharp volatility because of any sudden changes in the interest rates.
• Target Maturity Funds - These passive debt funds have a fixed maturity debt and hence, one can pick (and match) those funds which have the end date coinciding with the goal date. The fund managers add only those bonds in this scheme’s portfolio that typically mature around the fund’s maturity date. If held till maturity, these funds can help earn predictable returns.

With these categories clear, the next question is how many schemes to pick?

Should one fund be enough?

In my view, being over-diversified in debt funds is better than being under-diversified. Unlike equities where incremental benefits of concentration can be very high, the same cannot be said in the debt space.

Hence, for proper risk management, it is better to have schemes from 2-3 categories to build an all-weather debt portfolio where you won’t be constantly worried about trying to predict the next moves. So, while choosing, make sure to pick across above mentioned categories so that it combines portfolios of different maturities.

A healthy mix of schemes from shorter and longer-duration portfolios can work well for your long-term portfolio. A possible allocation can be having 33% each in Short Duration Fund, Gilt/Constant Maturity Funds, and Banking & PSU Debt Fund.

At times what will happen is that you will see certain debt funds that take high credit risk give great returns. Though it can be tempting to invest in it, I strongly suggest not taking undue credit risk just for the sake of extra 1-2% returns. If you have to take risks, do it via increased allocation to equity funds. Debt funds are part of the safe, peace-of-mind bucket and it’s better to let them be like that.

All said and done, hopefully, this discussion gives you enough ideas about how to go about building the debt side of your long-term portfolios. But remember that your requirements may be different from someone else and hence, be careful while picking debt funds. Different categories of debt funds take different levels of risks, and are suitable for different risk profiles, and goals. So, if in doubt, take help from a competent investment advisor.

Dev Ashish is a Sebi-registered investment adviser and the founder of Stable Investor