Building All-Weather Debt Portfolio

You may have heard of an all-weather equity portfolio, but an all-weather debt portfolio is as crucial for long-term capital protection. This article will help you understand and develop an all-weather debt portfolio for yourself

A majority of retail investors put their money into equity mutual funds. This is clear from data published by the Association of Mutual Funds in India (AMFI). Retail investors, including high net worth individuals, account for 88 per cent of equity-oriented schemes’ assets as of July 2022. When it comes to Debt Funds, institutional investors are the primary investors. Institutional investors own 87 per cent of liquid and money market schemes and 60 per cent of other debt-oriented schemes.[EasyDNNnews:PaidContentStart]

Institutional investors own the lion’s share (90 per cent) of exchange-traded funds (ETF) and fund of funds (FOFs). This demonstrates that retail involvement in debt funds is fairly low when compared to institutional participation. However, it still owns 40 per cent of the overall debt mutual fund assets. Investing in debt funds is frequently regarded as a safe haven, and is sometimes likened to bank fixed deposits (FDs). However, debt mutual funds provide much more. Debt mutual funds, like equity mutual funds, have a number of funds to meet a variety of needs.

Furthermore, based on the investing horizon of your financial objective, it is pretty convenient to invest in them. If your investing horizon is three years, you can invest in debt mutual funds with a three-year average maturity. However, investing in debt funds, or any fixed income product for that matter, may be difficult at times. This is due to the fact that timing the investment in debt funds is sometimes more crucial than timing the investment in equity funds.

Assume you have invested in a long duration fund in a rising interest rate environment. This will have devastating consequences. This is due to the inverse relationship between interest rates and debt fund returns. As a result, maintaining an all-weather portfolio of debt funds is advisable. You may have heard or read our article on how to develop an all-weather equity portfolio, but in this article, we will demonstrate how to build an all-weather debt portfolio.

Understand the Rationale

Investing in a solid balance of equity and debt mutual funds is always a smart idea. This is due to the fact that equities offer capital appreciation while debt provides capital protection. As a result, when it comes to returns, it is prudent not to compare debt funds to equity funds. This is due to the fact that the objective of investing in them is typically somewhat different from that of an equity fund. So, if you invest in them just for the prospect of high returns, you are taking excessive risks.

The graphs above display the annualised median equity and debt fund returns for the time period spanning January 2018 to March 2020. As can be seen, the highest median returns for any category in equity funds were 3.04 per cent, while debt funds had 11.57 per cent. Typically, investors fall into a trap here. They look at the high returns on debt funds and decide to invest in them. Consider what would have happened if you had invested in debt funds from April 2020 to August 26, 2022. 

As seen in the above graphs, if you had invested in debt funds based on their returns in March 2020, you may have missed the incredible returns produced by equity funds. If you want to preserve your capital, investing in debt funds makes sense. If you want to build wealth, equity funds are a better option.

Points to Note for All-Weather Debt Fund Portfolio

The fundamental reason for constructing such a portfolio is to liberate oneself from interest rate cycle timing and active participation. It is not, however, a portfolio that you can just buy and forget. An all-weather portfolio may be retained for the long term without requiring a lot of manoeuvring to deal with interest rate cycles or credit events. By investing in funds with different maturity profiles, a well-defined duration and credit risk boundary, one can build a fairly stable portfolio. This not only helps to manage interest rate and credit risk, but it also smoothens the portfolio’s return experience over time. However, this portfolio is not in any sense a high return portfolio, so you should be aware of that. If you follow the recommended technique in the following paragraphs, you will not have a high return debt fund portfolio. Even in debt funds, winners do rotate, just as in equity funds. As a result, there will always be some categories of debt funds that would fetch higher returns.

Characteristics of an All-Weather Debt Fund Portfolio

Maturity Profile ― Your portfolio should include a variety of maturity profiles. There will be periods when lower maturity securities do well, and other times when longer term papers perform well. As a result, having a decent mix would aid in minimising the portfolio’s overall duration risk.

Credit Risk Profile ― Unwise management of the credit risk fund might have unintended consequences. You should refrain from taking on more credit risk. In the portfolio, a moderate degree of credit risk is acceptable. With those additional returns, it would add some shine to your portfolio. However, you should keep this to no more than 10-15 per cent of your overall portfolio.

Diversify Across Fund House ― Investing your entire portfolio in funds managed by a single asset management company (AMC) might expose you to concentration risk. Remember the Franklin incident? If you had put all of your money into those six Franklin funds, it might have been a tragedy. Furthermore, each fund house has its unique approach to managing debt portfolios. Some, like Franklin Mutual Fund, may take adventurous bets, while others could opt to place conservative bets.

Actual All-Weather Debt Fund Portfolio
When constructing an all-weather debt portfolio, you should divide it into two groups: core and satellite. The core portfolio would be cautious, but the satellite would be focused on creating probably higher returns while not going overboard with risk. If you are a conservative investor, you may skip the satellite portfolio and put all of your money into the core portfolio. Only use the satellite portfolio if you are ready to take on greater risk.

Core Portfolio ―
When constructing an all-weather debt portfolio, the allocation to the core portfolio might range from 60-100 per cent. The precise allocation will be determined by your risk-return objectives, investment horizon and investment amount.

The portfolio shown above is made up of numerous debt funds. Low duration funds might help you control risk in the short term. Short duration funds, as well as banking and PSU debt funds would be advantageous in the short to medium term. Target maturity exchange traded funds (ETFs) can help you control interest rate risk in the medium to long term, while corporate bond funds will help you generate decent long-term returns with minimal risk. 

Satellite Portfolio ―

This portfolio’s major goal is to earn higher returns. As a result, risk would be an inherent component of this portfolio. Having said that, we recommend allocating from 0-30 per cent of your overall portfolio to satellite portfolio.



The above portfolio is relatively generic and may be tailored to your risk tolerance and expected return. Dynamic bond funds strive to produce alpha by actively managing interest rate risk. Credit risk funds take credit risk in order to make additional returns by betting on the credit cycle and spreads. Conservative Hybrid Funds are mainly focused on debt instruments, although they do include some equities. As a result, this fund would be exposed to some equity market risk. However, this combination would provide some zing to your portfolio.

Conclusion

Building a debt fund portfolio is just as crucial as building an equity mutual fund portfolio. Debt funds, on the other hand, require considerably more care since they are vulnerable to risks such as interest rate risk, credit risk, reinvestment risk, duration risk, and so on. As a result, we developed a roadmap for creating an all-weather debt portfolio. This portfolio will assist you in maintaining an appropriate balance of maturity profiles and credit risk. Having said that, it is prudent to divide the whole portfolio into core and satellite. Although we have made efforts to provide you some idea around creating an all-weather debt portfolio for yourself, it is most crucial to comprehend your risk tolerance and financial goals. Furthermore, the portfolio offered is generalised, and you may tailor it to your risk profile and expected returns. An allweather debt portfolio can assist you in achieving respectable capital protection with decent returns. 

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