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Construct A Robust Debt Portfolio During COVID-19

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Construct A Robust Debt Portfolio During COVID-19
Sandeep Das - 04 July 2020
For much over a month, media has been inundated with the news of Franklin Templeton shutting down six of its debt mutual funds. This has led to a growing concern among investors and is further aggravated by job losses, collapse of the services sector, volatile equity markets and balance sheet stress in corporate India. It is disconcerting when debt mutual funds, which are perceived as safe, are shut down unceremoniously.
Running away from debt instruments in these markets is suicidal, as capital preservation rather capital appreciation is of paramount importance.
It is important to construct appropriate debt portfolio during these times. Some of these instruments include AAA rated Corporate Bonds, Bharat Bond ETF, fixed savings schemes offered by the government and low risk debt funds. Some instruments best avoided include credit risk funds, dynamic bond funds, arbitrage and guilt funds along with bank fixed deposits.
Safety is important and due to superior tax benefits, you must be part of the debt capital markets.
Debt mutual funds provide significant tax benefits for retail investors at 20 per cent indexation, if held over three years. Hence, capital markets should not be avoided as other fixed income instruments charge 30 per cent as part of the highest income tax slab.
The two most prudent capital market oriented debt fund instruments include AAA rated Corporate Bonds and the Bharat Bond ETF, comprising AAA rated PSU paper. AAA rated Corporate Bonds have delivered a return of 8 to 9 per cent over five years, with 10 to 12 per cent return over the last one year, due to declining interest rates. As interest rates are unlikely to be significantly reduced, future returns of AAA rated Corporate Bonds might not be attractive but are likely to provide a return of 7 to 8 per cent going forward. With the safety of AAA rated paper, this is a sound debt instrument.
The Bharat Bond Exchange Traded Fund investing in AAA rated PSU is an excellent debt instrument. With AAA rated PSU, it has a default backing of the government and by being an index fund, it has a negligible expense ratio. It operates in two tenures - three years and 10 years and provides for likely post tax returns in the range of 5.5 to 6.0 per cent for the three-year tenure and 6.0 to 6.5 per cent return for the 10-year tenure.
Avoid all exotic debt instruments
The primary reason for the Franklin Templeton debt fund mishap is due to investing in paper with substantial credit risk. In a declining economy, as corporate balance sheets come under duress, companies with lower credit ratings tend to default putting retail investors in misery. Credit risk funds should be strictly avoided during this time. This is also indicated in the latest data for the month of April where these funds showed a net outflow of Rs 19,239 crore. In fact, any investment below AAA corporate paper is a huge source of risk.
In addition, dynamic bond funds where fund managers bet on the direction of interest rates should be avoided as well. Avoid arbitrage funds, gilt funds, hybrid funds and any debt fund type where you do not understand the underlying investment philosophy.
Fixed savings schemes offered by the government are sensible debt instruments
Certain fixed income instruments offered by the government/ government entities are highly recommended. In case you are a salaried employee, leveraging the voluntary provident fund, with a tax free return of 8.5 per cent, is highly recommended. In addition, deploying additional capital as part of the Kisan Vikas Patra with a pre-tax return of 7.3 per cent, National Savings Certificate with a pre-tax return of 7.6 per cent, Public Provident Fund with a tax free return of 7.1 per cent, are robust and safe government backed instruments.
It is additionally prudent to leverage overnight and liquid debt funds to park your loose money rather than letting them rot with a savings interest of 2.5 to 3 per cent. Avoid bank fixed deposits with pre-tax returns of 5.5 to 6 per cent at this point of time. Although if you are highly risk averse, bank FDs might be advisable for a portion of your debt portfolio.
With plummeting interest rates, real return on debt instruments might not significantly beat inflation
Over the last 18 months, RBI has been significantly cutting repo rates at 4 per cent to stimulate credit demand and revive the economy. As a result, the returns from fixed instrument vehicles like Kisan Vikas Patra, Public Provident Fund have been proportionally reduced. In addition, there is unlikely to be a rally in debt funds as there is limited room for repo rates to be further cut (as bond prices move in the opposite direction to interest rates). As a result, with inflation likely to be around 4.5 to 5.5 per cent, the real return on debt instruments is not likely to be very high. However, given the economic environment and the stress on bank loans and company balance sheets, capital preservation rather than capital appreciation should be the primary motive over the next 18 to 36 months.
For most retail investors debt as an asset vehicle should be in excess of 50 per cent of the portfolio
There are many theories on the portfolio weights of various asset vehicles. While the oldest one is on equity instruments constituting 100 - your age (%) in terms of asset allocation, given the ‘one in a century’ crisis, these theories rarely hold water any more. As everyone flocks to safety and with uncertainty looming around, it is prudent to build a debt portfolio that constitutes in excess of 50 per cent of your entire portfolio. This is recommended across age groups, income strata and financial education. If a significant portion of your assets are stuck in equity instruments, it might be a sensible decision to deploy a Systematic Withdrawal Plan over the next 18 months to switch over to a debt dominated portfolio.
Therefore, we can say that constructing a robust debt portfolio during such uncertain times is likely to hold you in good stead over the next 5 to 10 years.
The author is the Director, Pricewaterhouse Coopers (PwC)
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