When constructing portfolios the equity component usually recieves the most attention. But the debt component is usually not given as much time and effort. Debt as an asset class is not as exciting as equity. But it has as important a role to play in the portfolio. Therefore the debt component of any portfolio also deserves the same amount of awareness and effort that equity recieves.
The essential challenge in constructing debt portfolios comes from the fact that there are multiple product categories available to retail investors within the debt universe. These include bank deposits, small savings schemes, retirement contribution schemes, bonds, debt mutual funds and so on. Therefore it is important to first understand the nature of debt as an asset class. This would allow us to understand how to make best use of it in our portfolios. And this is what today's post will cover.
Debt as an asset class is primarily meant to achieve two things. Firstly, debt offsets the high degree of risk that is inherent with equity. It also provides stability and liquidity to an investment portfolio. The debt component of any portfolio is therefore not meant for long term growth. It is therefore essential to not chase returns from the debt component of the portfolio.
It is also just as essential to avoid investing in debt products that carry credit risk and/or interest rate risk. Examples of such products include long term bonds, gilt funds, credit risk funds, floating rate bond funds and so on. We would naturally be exposed to enough risk through the equity component of our portfolios. Therefore it makes no sense to increase the risk quotient of our portfolios by choosing such products for the debt component.
Bank deposits (savings deposits, recurring deposits and fixed deposits) are an integral part of any debt portfolio. It is therefore important for us to know how to use them effectively. All our deposits must be held with large, scheduled commercial banks. Deposits offered by companies, small finance banks and cooperative societies must be avoided. The same also goes for peer to peer lending. These entities are not as stringently regulated as commercial banks. They therefore carry a higher degree of risk in comparison to commercial banks. This is characterised by the fact that these entities offer a higher interest rate in comparison to commercial banks. The higher interest rate offered is meant to compensate investors for the additional risk involved.
Retirement contribution schemes offered by our employers (EPF, NPS) form an integral part of long term debt portfolios. The same can be said for government sponsored savings schemes (PPF, NPS, Sukanya Samriddhi Yojana). They offer tax free interest and/or a matching contribution from the employer. They must therefore be used optimally.
Those contributing to EPF may contribute to the full extent of the match offered by the employer. Contributions to Voluntary Provident Fund (VPF) must be capped within Rs 2,50,000 per financial year. Interest on contributions above Rs 2,50,000 in a financial year would be taxable at slab rates.
Those investing in PPF may make full use of the limit of Rs 1,50,000 each financial year. Those who are already contributing to an EPF account need not necessarily contribute to a PPF account. Otherwise the allocation to debt in the portfolio may become excessive in light of the desired asset allocation strategy for the goal. Therefore those contributing to both EPF and PPF must ensure that they balance out by investing adequately in equity. This would ensure that the desired asset allocation for the goal is maintained. An example of this fact is given in the graphic that follows.
Sukanya Samriddhi Yojana may be used to plan the education of a girl child who is less than 10 years old at the time of opening the account. Investing in NPS may not be advisable in most cases given the life circumstances of most professionals today. The only scenarios where NPS may make sense are as follows :
A. NPS offered by employer with a matching contribution
B. One is employed in a secure, tenured job (example : government officials)
C. Investments are limited to the tax deduction limit of Rs 50,000 per financial year.
D. An asset allocation of 85% government bonds and 15% equity is opted for in a tier 1 NPS account
Even in such cases, NPS retains very little relevance. For more on why I say this refer my earlier article, The Misunderstood Pension Scheme.
Let us now look at the use of debt mutual funds in a portfolio. The key thing to look at when selecting debt funds for our portfolios is the duration of the fund. The duration of a debt fund represents the weighted average maturity period of the bonds held by the fund. Say for example that the duration of a particular debt fund is 5 years. This means that the bonds held by the fund mature over a period of 5 years on average.
Higher the duration, higher the interest rate risk of a debt mutual fund. The duration of a debt fund selected for a goal must be significantly lower than the tenure of the goal. This minimises interest rate risk. It is advisable to select a debt fund whose bonds mainly have a AAA, A1 or Sovereign credit rating. This minimises credit risk.
This implies that funds with low duration, low interest rate risk and low credit risk are ideal for portfolios. Liquid funds and overnight funds therefore represent ideal debt fund categories for our portfolios. Debt portfolio construction therefore boils down to the following tenets :
A. Not chasing returns
B. Preferring deposits offered by large scheduled banks
C. Making optimal use of retirement contribution schemes offered by our employers and/or the government
D. Using debt mutual fund categories that offer low duration, credit risk and interest rate risk
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