{"id":17117,"date":"2020-01-06T15:45:48","date_gmt":"2020-01-06T10:15:48","guid":{"rendered":"https:\/\/www.fundsindia.com\/blog\/?p=17117"},"modified":"2020-05-12T08:50:57","modified_gmt":"2020-05-12T03:20:57","slug":"debt-mutual-fund-portfolio-construction-framework","status":"publish","type":"post","link":"https:\/\/www.fundsindia.com\/blog\/mf-research\/debt-mutual-fund-portfolio-construction-framework\/17117","title":{"rendered":"Debt Mutual Funds – Portfolio Construction Framework"},"content":{"rendered":"

In recent times, debt mutual funds<\/a> have been in the limelight, primarily because of NAV declines in few funds led by credit downgrades and defaults. While the credit-related risks were always there across funds with exposure to lower credit securities, the fact that they did not play out for a long time had led to under-appreciation of credit risks in debt mutual funds<\/a>. Interest rate risks, on the other hand, since they frequently play out via volatile NAV movement for long-duration based debt mutual funds based on interest rate movements, is better understood by most investors.<\/span><\/p>\n

Given our learnings from this cycle (both from our mistakes as well as others’), we have brought in significant improvement and changes to our debt fund selection and portfolio construction process especially in terms of risk management.<\/span><\/p>\n

In the coming few weeks, over a series of new posts, we would like to introduce you to our investment thought process, framework, and investment philosophy.<\/span><\/p>\n

Understanding Risks in Debt Mutual Funds<\/b><\/h4>\n

There are two major types of risks associated with a debt mutual fund.<\/span>
\n<\/span>
\n<\/b>1) Interest rate risk: <\/b>Risk of decline owing to changes in interest rates.<\/span><\/i><\/p>\n

This is the risk that interest rates may rise and cause a fall in the value of traded bonds and hence lead to lower returns. Interest rates and portfolio values\/NAVs move in opposite directions. Further, the NAVs would fluctuate more for a long maturity fund and less for a short maturity fund. This risk is best captured by the modified duration of the fund.\u00a0<\/span><\/p>\n

The reason why fund managers take this risk is to target higher returns by increasing the modified duration if the expectation is for a decline in interest rates and vice versa.<\/b><\/p>\n

2) Credit risk:<\/b> Risk of decline\/loss owing to change in the credit profile of an issuer that leads either to downgrade or default.<\/span><\/i><\/p>\n

This is the risk that the issuer will not pay the coupon income and\/or maturity proceeds on the specified dates. This could also lead to a decline in the portfolio values\/NAVs due to a downgrade in the credit rating or default.\u00a0<\/span><\/p>\n

The reason why fund managers take this risk is lower credit-rated papers, if managed well without defaults and minimal downgrades, can be used to target higher returns from the higher yields available in lower credit-rated papers.<\/b><\/p>\n

Now the key question for us is <\/b>
\n<\/b>
\n<\/b>To what extent do we need to take both the above risks for improving our debt portfolio returns?<\/b><\/h4>\n

To help us manage these risks better and set the right return expectations in our debt portfolios, we suggest a 3 bucket debt portfolio construction framework.\u00a0<\/span><\/p>\n