In a year buffeted by downgrades and default, one category of debt funds saw a surge in assets under management (AUM)—banking and PSU debt funds. The category has seen its AUM rise from ₹35,682 crore as of 30 April to ₹58,345 crore as of 31 October, an increase of 63%. In contrast the total AUM of debt funds in India rose by a mere 5% over the same period from ₹10.88 trillion to ₹11.44 trillion. So does that makes a case for you to invest in this category? We tell you what these funds are and whether or not you should invest in them.
The banking and PSU debt category was created by the Securities and Exchange Board of India (Sebi) in October 2017. These funds were mandated to invest at least 80% of assets in debt issued by banks (private or public) or public sector financial institutions or public sector undertakings but an amendment to Sebi rules in December 2017 included debt issued by municipal bodies in the list of permitted investment categories. Public sector enterprises are seen as safe because they have an implicit government guarantee. Banks, being regulated tightly by the Reserve Bank of India (RBI), are also seen as relatively low-risk. However, in return for the safety quotient, such funds give a relatively low yield.
The category has also done well over the past year. On average, the category delivered 10.81% (as of 15 November), according to data from Value Research. Over the past three and five years, it has given 7.38% and 8.11%, respectively, although these figures are less useful than more recent numbers. This is because there was no formal definition for the category before Sebi’s 2017 rules and these funds had fairly diverse strategies.
Banking and PSU debt funds also invest in relatively liquid papers. “Since minimum 80% of scheme assets are typically invested in banking PSU issuers, which are well held across investor categories, regularly traded and hence have better price discovery, these are well suited for conservative investors," said Anurag Mittal, associate director, fund management, fixed income, IDFC Mutual Fund. “But investors should look at actual portfolios of schemes to get a sense of actual risk," he added.
Their closest peers, corporate debt funds (which are mandated to invest 80% of assets in debt rated AA+ and above) delivered just 6.65% over the past year. They gave 5.17% and 6.81%, over the past three and five years, respectively, but again the older figures are of limited value for the reasons mentioned earlier. Some funds in the corporate debt category slipped up spectacularly as debt that was once rated AAA (such as DHFL) subsequently defaulted. Interestingly, corporate bond funds have also seen their assets grow from ₹61,329 crore in April 2019 to ₹71,263 crore in October 2019, a rise of 16%.
Should you invest?
There are reasons to be skeptical of returns from the category despite stellar performance over the past year. The year gone by was characterized by a gathering debt storm which began with IL&FS debt defaults in September 2018 and spread to other companies. This prompted a flight to safety allowing highly rated debt to outperform its lower rated counterparts and, hence, banking and PSU debt funds did extremely well compared to their peers. But it is unclear whether the next three-four years will see a repetition of the crisis or not.
Moreover, not all the funds can be painted with the same brush. “Some element of credit risk is there in all issuers except a pure sovereign paper," warned Mittal. “A conservative credit investor can look at AAA oriented banking PSU funds," he added. Dwijendra Srivastava, head, fixed income, Sundaram Mutual Fund, also highlighted some of the residual credit risks of the category. “Not all banking debt is AAA and some of these funds also have AT1 (perpetual bonds) issued by banks which are not actually pure debt products (they are somewhere between debt and equity)," he said. AT1 bonds have no maturity date. If the bank’s common tier 1 capital ratio falls below 6.125%, AT1 bonds absorb the losses. The bank can choose to skip the coupon in such a scenario.
The yields-to-maturity (YTMs) of the three largest funds in the category—IDFC Banking and PSU Debt, Axis Banking and PSU Debt and Aditya Birla Sun Life Banking and PSU Debt—are 6.79%, 6.55% and 6.52%, respectively. Roughly, a fund’s YTM minus its expense ratio gives you the return it may earn, assuming there are no dramatic credit upgrades or downgrades. Since most of the debt held by these funds is already rated AAA, there is little upside from credit upgrades. An expected return of 6.5-7% does not score much above a bank fixed deposit or a money-market fund.
Interest rate cuts could be another source of higher returns. Rate cuts pack the greatest punch for funds which have two-three years of modified duration, roughly the same as that of these funds. The modified duration of a fund tells you how much it will gain for every 1% cut in interest rate. IDFC, Axis and Aditya Birla Sun Life banking and PSU debt funds have modified durations of 2.6, 2 and 2.04 years, which are relatively modest. This means that gains from rate cuts in these funds will be limited. In addition, a spike in inflation in October has reduced the chances of further rate cuts.
The banking and PSU debt category is more about safety than returns. “With one or two more rate cuts expected from RBI, these funds will do better than, say, liquid funds," said Srivastava. Investors looking for low risk over a smaller horizon could look at these funds. “Even though these funds offer modest yields, they are at a reasonable spread to the repo rate," said Gaurav Awasthi, senior partner, IIFL Wealth Management Ltd, a financial advisory firm. “An investment horizon of two years or more will be most desirable for this category. In addition, a horizon of three years or more will also attract the benefit of long-term capital gains (thereby indexation) for these funds," said Mittal.
However, do not expect returns higher than a bank fixed deposit of a similar tenure.