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Which category of debt mutual funds is best for rebalancing?

This article helps you decide which debt mutual fund category to choose when rebalancing between debt and equity.

Which category of debt mutual funds is best for rebalancing?


Posted on 22 Feb 2023
Author: Sayan Sircar
9 mins read
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This article helps you decide which debt mutual fund category to choose when rebalancing between debt and equity.

Which category of debt mutual funds is best for rebalancing?

Summary:
  • We discuss which type of debt mutual funds are suitable for rebalancing portfolios between equity and debt by providing a comparison between four types of debt mutual funds, liquid funds, money market funds, gilt funds, and corporate bond funds
  • We perform the analysis of three metrics - one-year rolling returns, correlation with equity, and rolling deviation from equity
  • We conclude that investors should choose debt fund categories for rebalancing with the lowest credit and interest rate risk since there is little incentive to take higher risk


📚 Topics covered:

What is rebalancing inside a portfolio?

Portfolio rebalancing during goal-based investing: why, when and how?

Rebalancing is a vital risk management tool to achieve one objective: portfolio risk over time needs to be managed per market movement and horizon of the goal. For example, bull markets increase the portfolio’s equity component, increasing the portfolio’s risk once a market correction comes. Having the plan to rebalance from equity to debt manages this risk. Similarly, a bear market has a buying opportunity if you sell a part of debt holdings to buy equity. Also, as the goal comes closer, the portfolio’s risk must be lowered by lowering the equity component. Rebalancing allows this as well.

Rebalancing allows you to

  • Systematically buy low and sell high
  • Should be done at the portfolio level (all goals together to minimize the number of trades and taxes)

Here is a detailed post on how to get your risk profile for any goal in case you want to review that first.

In general, rebalancing is a trade-off where you balance the effects of mean reversion (what goes up will eventually come down and vice versa) and momentum (what goes up/down will keep going up/down for some time). Thus, there is no need to time market top/bottom while rebalancing as long as a systematic process is followed.

To know more about rebalancing, please check out this article: Portfolio rebalancing during goal-based investing: why, when and how?.

We will use mutual funds to create and manage a long-term portfolio like for retirement or children’s education goals. For such portfolios, we will examine which type of debt mutual funds are most suitable for rebalancing purposes.

Why do you need a debt fund for rebalancing?

Case 1: 100% equity and no debt

Case 1 with 100% equity and no debt

Here is an example of a 15,000/month SIP run for 15 years. The SIP amount is increased by 5% every year. The chart shows ten different possibilities assuming the average equity return is 11% post-tax and risk of 15%. The results are:

  • maximum value: ₹ 166 lakhs
  • minimum value: ₹ 44 lakhs

Here is our article about the danger of having only equity without rebalancing: The lie of wealth-creation via SIP in mutual funds

Case 2: 60:40 fixed equity and debt asset allocation and then rebalanced

Case 2 60:40 fixed asset allocation and then rebalanced

The variation in the previous case is the effect of market risk, showing us that the equity market returns are unpredictable. Since we need market risk to make high returns, we need a way to manage this risk. Rebalancing via a suitable asset allocation is the solution by allocating to equity and debt. For this example, we will invest 60% in equity and 40% in debt and keep this allocation fixed for 15 years by rebalancing annually. We will use the same sequence of equity returns as before. As these results show (corpus range of ₹49-108 lakhs), the variability is now lower.

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Which types of debt mutual funds are there?

SEBI Debt fund matrix Jun 2021

Now that we have made a strong case for including debt mutual funds in the portfolio for regular rebalancing, we will explore which type of debt fund is most suitable. Of the 17 types of debt mutual funds currently available, as per the SEBI mutual fund classification scheme, we have spoken about the following two categories, which fall in the top left quadrant of the chart:

Along with these, we add two other common categories:

For equity, we choose the category of Nifty 50 index funds.

We will perform our analysis for these four debt fund categories using the following three metrics:

  • the rolling year of the fund for a one-year holding period
  • correlation of rolling returns of debt vs equity
  • rolling one-year absolute deviation (equity - debt return squared) added over one year calculation period

Also read
Do you need to pay for children's education or marriage?

Analysis results

One-year rolling returns

1-year rolling returns for debt mutual funds

We calculate simple rolling returns for all of the debt funds like this:

  • 1st Jan 2007 to 31 Dec 2007
  • 2nd Jan 2007 to 1st Jan 2008
  • 3rd Jan 2007 to 2nd Jan 2008 etc., and then plot them.

As the chart shows, gilt funds have the highest fluctuations, up and down, due to changes in interest rates. Conversely, liquid funds have minor fluctuations because credit risk exposure is minimal. The same applies to their interest rate risk exposure since they hold only 91-day T-Bills.

Investors choosing debt fund categories should be comfortable with the level of fluctuation they might get from their debt mutual fund. You can estimate the exposure to risk by reading the portfolio disclosure statement of the fund: How to understand the portfolio composition of a debt mutual fund?.

Correlation with equity

Debt Fund Correlation with equity

Correlation is a statistical measure of how two things behave vs each other

If you want to understand the concept of correlation in the simplest possible way, think about two kids in play school:

  • they always play together since they are best friends: correlation of +1
  • they always play in different places since they are enemies: correlation of -1
  • they always play unpredictably in different places on some days and other days, play together since they are kids and do whatever they want: correlation of 0

As the diagram shows

  • all debt funds have a negative correlation vs equity, showing that they generally move in different directions. When equity goes up, debt falls and vice versa, allowing periodic rebalancing by buying low and selling high
  • liquid funds have the most stable returns vs the rest and show the most negative correlation vs equity

Rolling deviation from equity

Rolling deviation from equity for debt mutual funds

Deviation = Sum of [(Equity 1-y return - Debt 1-y return) ^ 2] over 1 year

We want the highest possible deviation between equity and debt since it measures how differently equity and debt move. So we have taken a 1-year rolling return, squared the difference to get rid of the sign, and then summed it up over the last 1-year’s values.

The chart shows that the various categories in the recent past are the same, and there is no consistent trend. Only post-2008, due to falling interest rates and high fluctuations in equity post the Global Financial Crisis, there was a considerable difference between equity and gilt compared to the rest.

Which debt fund categories should investors use for rebalancing?

As evidenced in this article, we stick to our stance on using debt mutual funds with the lowest credit and interest rate risk like this.

SEBI Debt fund matrix

Decision making framework:

Pre-requisite: Goal > 3 years since otherwise, you can use FD

  • Category of fund: overnight, liquid, ultra-short, low duration or money market funds only with Macaulay duration <= 1 year (alternatively modified duration <= 1 year) [Class I: (Macaulay Duration <= 1 year) as per SEBI]
  • Credit-quality of portfolio: mix of SOV/AAA/A1+/Cash only [Class A (CRV >= 12) as per SEBI]
  • Maximize the expected return after factoring in YTM, TER, modified duration and the portfolio quality
  • Only invest in DIRECT GROWTH funds

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This post titled Which category of debt mutual funds is best for rebalancing? first appeared on 22 Feb 2023 at https://arthgyaan.com


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