passive debt funds in india: features & strategies

Passive Debt Funds in India: Features & Strategies

An iFAST Research Report | August 2021

Krishna Karwa

Senior Research Analyst, iFAST Financial India Pvt Ltd

iFAST Financial India Pvt Ltd Proprietary 1

Preface

Passive investing has been making rapid inroads in India's mutual fund industry with growing

awareness of low-cost investment products. While the equity based passive products are well-

discovered and reasonably understood by now, passive debt products have been comparatively slow

to enter the market. This is understandable, since fixed income investment returns require complex

and dynamic calculations, unlike returns on equity investments that have a linear relationship with

market movements.

AMCs have risen to the challenge, and in the last year and a half , we have seen a spate of debt-based

exchange traded funds (ETFs) and index funds being launched. The passive debt products we now

have in India have clearly differentiated attributes versus the actively managed funds. Upon study, we

realised that these differences make passive debt funds a valuable tool for financial planners,

distributors and advisory practitioners.

In this report, we study the landscape of the available debt mutual funds* by segregating them into

the following three groups:

Passive debt funds with predefined maturity

Passive funds with no predefined maturity

Active debt funds

Apart from studying the defining attributes of each category, we offer guidance on suitability for

investors, as well as important caveats to bear in mind when selecting each.

We hope the insights prove fruitful. Happy investing!

* This report addresses open-ended funds only. Fixed Maturity Plans (FMPs) are an entirely different product and are not

part of the comparison.


Glossary

Term Abbreviation

AMC Asset Management Company

CDL Central Development Loan

CPSE Central Public Sector Enterprise

FD Fixed Deposit

G-Sec Government Securities

MF Mutual Fund

PSU Public Sector Undertaking

RBI Reserve Bank of India

SDL State Development Loan

SIP Systematic Investment Plan

STP Systematic Transfer Plan

SWP Systematic Withdrawal Plan

YTM Yield to Maturity (also referred to as ‘yield’)


Contents

Landscape of Debt Mutual Funds in India ....................................................................................... 4

Key Attributes of Passive Debt Funds ............................................................................................. 5

Investment horizon ................................................................................................................... 5

Return profile ........................................................................................................................... 6

Interest rate risk ....................................................................................................................... 6

Credit risk/G-sec exposure risk .................................................................................................. 6

Transactional attributes ............................................................................................................ 6

Positioning Debt in Portfolios ........................................................................................................ 8

Passive debt funds with predefined maturities ........................................................................... 8

Passive debt funds without predefined maturity......................................................................... 8

Active debt funds...................................................................................................................... 9

Debt funds as per risk profile ................................................................................................... 11

Conclusion ................................................................................................................................. 11


Landscape of Debt Mutual Funds in India

The following table presents the debt mutual funds available in India at the time of writing this report.

Active open-ended debt funds are too many to enumerate, so only the categories have been listed.

Table 1: Debt Mutual Funds Available in India

Investment Horizon

Duration Passive Debt Funds (Predefined Maturity)

Passive Debt Funds (No Predefined Maturity)

Active Debt Funds (Categories)

Temporary < 6 months - Nippon India ETF Liquid

Bees

- Overnight

- Liquid

- Ultra Short Term

Short Term 6-12 months

- - - Low Duration

- Money Market

Short to

Medium Term

1 – 3 years - Bharat Bond ETF 2023 - - Short Duration

- Nippon India ETF Nifty CPSE Bond Plus SDL – 2024

- Floater

Medium Term 2 – 5 years - Bharat Bond ETF – April

2025

- Motilal Oswal 5-Year G-

Sec ETF

- Corporate Bond

- Nippon India ETF SDL Nifty SDL – 2026

- Nippon India ETF 5-Year Gilt

- Banking & PSU

- Axis AAA Bond Plus SDL

ETF – 2026

- Medium Duration

- Edelweiss Nifty PSU Bond Plus SDL Index Fund – 2026

- Credit Risk

Medium to

Long Term

5 – 7 Years - IDFC Gilt 2027 Index

Fund

- - Dynamic Bond

- IDFC Gilt 2028 Index Fund

- Medium to Long Duration

Long Term > 7 Years - Bharat Bond ETF - April 2030

- LIC MF G-Sec Long Term ETF

- Long Duration

- Bharat Bond ETF – April 2031

- Nippon India ETF Long Term Gilt

- G-Sec

- SBI ETF 10-Year Gilt - G-Sec with 10-

Year Fixed Maturity

iFAST Compilations | Data as on August 23, 2021


Key Attributes of Passive Debt Funds

Passive debt funds, comprising exchange traded funds (ETFs) and index funds, replicate an underlying

debt benchmark and thus offer returns approximating it. In doing so, they have to comply with the

following SEBI norms1 for passive debt funds:

(a) The constituents of the index shall be aggregated at issuer level.

(b) The index shall have a minimum of 8 issuers.

(c) No single issuer shall have more than 15% weight in the index.

(d) The rating of the constituents of the index shall be investment

grade.

(e) The constituents of the index shall have a defined credit rating

and defined maturity as specified in the index methodology.

The norms are reassuring from an investor protection point of

view, as they define the permissible concentration and credit risk

of the underlying investments of passive funds.

Interestingly, while the guidelines allow passive debt funds to

choose from among all investment grade products, the currently available passive debt funds primarily

pertain to bonds issued by central and state governments, public sector undertakings and AAA rated

private corporations. With this, asset management companies (AMCs) are taking a clear direction in

terms of minimising credit risk in passive debt funds, which is an important indicator of the products’

suitability.

Let’s delve further into other key attributes of passive debt funds, and what they mean for investors.

Investment horizon

At this point, most of the passive debt funds are available for medium and long term periods . This

seems to be geared towards encouraging investors to hold units for at least three years and derive

taxation benefits.

In comparison, active debt funds are available for the full range of tenures, from one day to over 10

years. This allows for a more customised approach for investors, who can choose from across several

categories depending on the maturity profile they want in their portfolio.

1 https://www.sebi.gov.in/legal/circulars/nov-2019/norms-for-debt-exchange-traded-funds-etfs-index-funds_45146.html

Asset Management

Companies are taking

a clear direction in

terms of minimising

credit risk in passive

debt products. This is

an important

indicator of the

products’ suitability

for investors.

https://www.sebi.gov.in/legal/circulars/nov-2019/norms-for-debt-exchange-traded-funds-etfs-index-funds_45146.html

https://www.sebi.gov.in/legal/circulars/nov-2019/norms-for-debt-exchange-traded-funds-etfs-index-funds_45146.html


Return profile

Passive debt funds with predefined maturity are an interesting product for investors, as the tentative

yield to maturity (YTM) is known at the time of investment. Assuming they stay invested till maturity,

investors can lock their investments at a certain yield at the point of investment.

Passive debt funds with no predefined maturity and active debt funds tend to witness changes in yields

depending on how prices of underlying debt instruments change

over a period of time.

Interest rate risk

In case of passive funds with predefined maturity, there is no

interest rate risk if units are held till maturity. However, if the

investor sells before maturity, the NAV of the fund will be

determined by the prevailing NAVs of the underlying debt securities

at the time, and it can be higher or lower than the investor’s entry

price. Passive funds with no predefined maturity and active debt

MFs investing in medium to long term debt instruments are

sensitive to interest rate movements, and thus have volatile NAVs in response to interest rate cuts or

hikes by the Reserve Bank of India (RBI).

Interest rate sensitivity is an important attribute currently, since the RBI wil l have to step in at some

point to tackle inflation and prevent overheating in the economy. If inflation remains persistently high

above the central bank’s upper band of 4 percent, a hike in the repo rate is certain eventually.

Credit risk/G-sec exposure risk

As discussed, passive debt funds currently carry minimal credit risk since the issuers of debt are

primarily governments or government-backed enterprises. In contrast, active debt funds are

vulnerable to defaults to the extent of exposure to private sector corporate bonds.

However, it is worthwhile noting that even funds with higher exposure to government securities are

vulnerable to price changes. In instances of revenue shortfall, central and state governments may be

forced to borrow more than what the debt markets anticipate. This will lead to a higher supply of G-

Secs in the market, in turn causing the NAVs of passive and active debt funds that invest heavily in

them, to decline.

Transactional attributes

Expense ratios of passive debt funds are lower than those of active debt funds since there is no need

to manage duration and credit quality. Active debt funds have the flexibility to alter their portfolio,

subject to guidelines defined by SEBI and the AMC's framework. As a result, their expense ratios tend

to be higher.

Assuming they stay

invested till the end,

investors can lock

their investments at a

certain yield in

passive debt funds

with predefined

maturity.


In passive debt funds, investments/redemptions are undertaken based on day-end NAVs (in index

funds) or real-time NAVs on the exchange (in ETFs). For active funds, investments/redemptions are

undertaken based on day-end NAVs.

In the context of passive debt funds, investments through SIPs can be undertaken only in index funds,

whereas a demat account is mandatory for ETF transactions. In active funds, investors can invest

through SIPs and lumpsums, and a demat account is not mandatory.


Positioning Debt in Portfolios

Across all debt funds, we recommend investing primarily at the shorter and medium end of the

duration curve currently, given the heightened interest rate risk. While short term funds can help limit

volatility, medium term options offers a good risk-return trade-off if the units are held on for at least

3 years (from a taxation perspective).

Investing at the longer end of the duration curve is only ideal after interest rates have moved up.

We now look at specific recommendations for the three categories of debt mutual funds.

Passive debt funds with predefined maturities

These are best suited to risk-averse investors seeking predictable return over the medium to long

term. For instance, individuals who a) are likely to hold on till maturity, and b) do not wish to encounter

uncertainty in expected return in their portfolios, can look at this category.

If a debt fund has meaningful exposure to credit risk, duration being similar, its yields should be higher

than funds with lower credit risk. At this juncture, our three preferred passive debt funds with

predefined maturities have lower credit risk and yet their yields are higher than funds with

comparatively higher credit risk and exposure to corporate bonds. Therefore, they present very

attractive investment options for investors to consider.

Table 2: Recommended passive debt funds with predefined maturity

Investment horizon

Fund TER Parameters as on July 31, 2021 (For July 2021)

Yield to maturity

Average maturity

Modified duration

(%) (Years)

Short to medium term

- Bharat Bond ETF - April 2023 0.0005 4.53 1.67 1.52

(1 - 3 years ) - Nippon India ETF Nifty CPSE Bond Plus SDL - 2024 Maturi ty

0.15 5.28 2.98 2.57

Medium term - Bharat Bond ETF - April 2025 0.0005 5.64 3.57 3.05 (3 - 5 years ) - Nippon India ETF Nifty SDL - 2026

Maturi ty 0.15 6.13 4.49 3.67

- Axis AAA Bond Plus SDL ETF - 2026 Maturi ty

0.15 5.90 4.22 3.46

- Edelweiss Nifty PSU Bond Plus SDL Index Fund - 2026 Maturi ty

0.31 6.08 4.54 3.73

Modified duration represents the degree of interest rate risk. Higher the number, higher the risk. Source: iFAST Compilations

Passive debt funds without predefined maturity

Without a defined maturity, these funds carry high interest rate risk currently and should be looked

at only by risk-taking investors with a medium to long horizon. It’s best to consider investing in such


funds after a rate hike cycle has begun since there is no scope to tweak the maturity of debt

instruments in the portfolio.

To elaborate, an investor with a 5-year horizon can look at a 5-year G-Sec ETF (no index fund option

available in this category). Return at the end of 5 years will be contingent on how the interest rate

cycle and the central government’s borrowing plan pans out during this period. Yields (and therefore

return prospects) will keep changing over a period of time.

Table 3: Recommended passive debt funds without predefined maturity

Investment horizon

Fund TER Parameters as on July 31, 2021 (For July

2021)

Yield to

maturity

Average

maturity

Modified

duration (%) (Years)

Medium term Nippon India ETF 5 Year Gi l t

0.09 5.68 4.59 3.91

Modified duration represents the degree of interest rate risk. Higher the number, higher the risk. Source: iFAST Compilations

In the current scenario, investors looking to manage duration (and interest rate risk) can therefore

consider active funds instead.

Active debt funds

Exposure to this category can be highly customised after considering an inve stor’s investment horizon

and tolerance to credit/interest rate risks. This makes them worthwhile for any investor. For example,

investors can choose from funds with average maturities of 1 day (overnight funds) to over 10 years

(long duration funds). Those who don’t wish to take credit risk can choose categories/funds that

predominantly invest in high credit rated debt instruments.

Unlike passive funds with a predefined maturity, yields (and return prospects) of active debt funds

may move up or down depending on conditions prevailing in the debt market. Only investors who can

bear volatility in NAVs during the course of their investment horizon should consider active funds.

In comparison to passive funds with no predefined maturity, active funds have an e dge at this juncture

owing to the flexibility of the fund manager to manage duration (as per SEBI’s stipulated guidelines).

This, in turn, will help limit interest rate risk.

Our recommended funds across categories are as follows:

Table 4: Recommended active debt funds

Investment

horizon

Category Fund TER Parameters as on July 31, 2021

(For July 2021)

Yield to maturity

Average maturity

Modified duration

(%) (Years) Short term (Up to 1 year)

Liquid (Up to 3 months)

- Axis Liquid Fund 0.25 3.50 0.09 0.08 - Aditya Birla Sun Li fe

Liquid Fund

0.33 3.60 0.09 0.09

Ultra short duration

(3 - 6 months)

- HDFC Ultra Short Term

Fund

0.64 3.92 0.48 0.45


Investment horizon

Category Fund TER Parameters as on July 31, 2021

(For July 2021)

Yield to maturity

Average maturity

Modified duration

(%) (Years)

- SBI Magnum Ultra Short Duration Fund

0.49 3.69 0.46 0.32

Low duration (6

months - 1 year)

- Kotak Low Duration

Fund

1.18 4.51 1.77 0.84

- Axis Treasury Advantage Fund

0.61 4.16 0.91 0.68

Short to medium

term (1 - 3 years )

Short duration - HDFC Short Term Debt Fund

0.79 5.08 2.95 2.13

- IDFC Bond Fund - Short Term Pl an

0.77 4.65 2.14 1.86

Floating rate IDFC Floating Rate Fund 0.75 4.03 1.07 0.68 Medium term (3 - 5 years )

Corporate bond - Kotak Corporate Bond Fund

0.66 5.11 2.63 1.58

- HDFC Corporate Bond Fund

0.61 5.32 4.16 2.68

Banking & PSU - Kotak Banking & PSU Debt Fund

0.77 5.61 4.70 2.57

- Nippon India Banking &

PSU Debt Fund

0.79 5.08 3.16 2.37

Medium duration - SBI Magnum Medium

Duration Fund

1.21 5.49 2.77 1.81

- HDFC Medium Term

Debt Fund

1.30 6.38 4.02 3.00

Credit ri sk ICICI Prudential Credit Risk Fund

1.57 7.07 2.68 1.92

Modified duration represents the degree of interest rate risk. Higher the number, higher the risk.

Source: iFAST Compilations

Investments in liquid (3 months) and ultra-short duration funds (3-6 months) are low-risk, low-yield in

nature and should be used to park funds temporarily or to initiate STPs/SWPs. Since low duration

funds (up to 1 year) invest for a relatively longer period, yields are slightly higher.

Those who wish to bridge the gap between short and medium term investing can look at short

duration and floating rate funds. As per SEBI’s mandate, short duration funds must ensure that the

Macaulay duration (represents the weighted average time period to receive all cash flows from all

debt instruments) of the portfolio is between 1 and 3 years, whereas floating rate funds are

advantageous at a time when interest rates are slated to move up.

In the medium term basket, some degree of interest rate risk is a given. The focus should therefore be

on minimising credit risk in order to limit volatility in NAVs. We recommend prioritising corporate

bond funds and banking & PSU debt funds owing to their exposure in high-rated debt instruments.

Investors who wish to derive better yields, albeit with some degree of credit risk, can consider medium

duration funds, where the Macaulay duration, as per SEBI’s mandate, ought to be between 3 and 4

years and there is no regulation regarding the credit quality of the debt instruments.

As per SEBI’s definition, credit risk funds are required to invest minimum 65 percent of the portfolio

in debt instruments that are not the highest rated in terms of credit quality. Though yields can be high

despite a shorter maturity profile, this category is extremely vulnerable to adverse dynamics in the

debt markets. This is particularly true in cases where marquee names default and/or liquidity risk for


low-rated debt instruments spikes. Only investors with a high appetite for risk should consider this

category.

Debt funds as per risk profile

Risk profile Passive debt funds Active debt funds

Predefined maturity No predefined maturity

Conservative

Moderately conservative

Balanced

Moderately aggressive

Aggressive

Source: iFAST Compilations

Conclusion

Given that interest rates are expected to rise over the next two years, we recommend that risk -averse

investors consider passive debt funds with predefined maturities as they offer certainty of returns

when held to maturity. As on today, for a similar duration, their yields are higher than those of passive

debt funds without predefined maturities.

In times of high inflation, debt funds are vulnerable to negative real returns. We expect the short to

medium term inflation rate to be in the range of 5–5.5 percent. To derive yields higher than this mark,

some degree of credit risk (by way of exposure to debt instruments other than G-Secs, quasi G-Secs

and AAA corporate bonds) and/or interest rate risk (by investing in debt instruments with medium

and long term maturities) will therefore have to be taken in one’s core portfolio.

Furthermore, when putting in place an asset allocation framework, investors’ exposure to debt funds

should be complemented with exposure to domestic and global equities in accordance with their risk

profile.


Disclaimer

iFAST and/or its content and research team's l icensed representatives may own or have positions in the mutual

funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to

time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or

solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken

without first viewing a mutual fund's scheme information document including statement of additional

information. Any advice herein is made on a general basis and does not take into account the specific investment

objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and

legal advice before making an investment or any other decision. Past performance and any forecast is not

necessarily indicative of the future or l ikely performance of the mutual fund. Opinions expressed herein are

subject to change without notice.

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