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    Home»Mutual Funds»How to maximize returns on your debt mutual fund investments
    Mutual Funds

    How to maximize returns on your debt mutual fund investments

    March 18, 2025


    The 10-year Indian bond yield, once trading at 12-13% in the late 90s, has now dropped from its 5-year high of around 7.5% to 6.7% as of February-end 2025.

    With the start of the interest rate cut cycle, yields are expected to fall further. And with no indexation benefits in debt mutual funds, this raises an important question: “How can investors maximize on their fixed income returns?”

    Typically, there are two ways to maximize debt mutual fund returns – 1. By taking credit risk (investing in risky lower-graded debt instruments) and 2. By taking duration risk (investing in safer, high-graded long maturity debt instruments). Let us see how these strategies have played.

    We have considered popular funds in equal allocation from these three debt categories – 1. Credit Risk Funds (HDFC, Kotak, ICICI & SBI), 2. Corporate Bond Funds (HDFC, Kotak, ICICI & ABSL) and 3. Constant Maturity Gilt Funds (ICICI & SBI).

    In terms of a 3-year-daily rolling CAGR returns from 1 Jan 2018 to 28 Feb 2025, credit risk funds generated a 7% CAGR on average, an 8.8% CAGR at the maximum and 5.4% CAGR at the minimum, corporate bond funds at 7.3% CAGR on average, 9.2% CAGR at the maximum and 4.9% at the minimum and lastly constant maturity gilt funds at a 7.8% CAGR on average, 11.7% CAGR at the maximum and 3.2% CAGR at the minimum.

    As on 28 Feb 2025, average 3-year CAGR returns of credit risk, corporate bond and constant maturity gilt funds stand at 6.3%, 6.7% and 6.5%, respectively. As on February-end 2025, average gross yield to maturity of credit risk funds (8.6%) is just around 1% higher than corporate bond funds (7.5%) and with the high expense ratios of credit risk funds, this difference will substantially narrow down much below 1%.

    Data shows corporate bond funds and constant maturity gilt funds outperformed credit risk funds at many points and have managed to deliver better risk adjusted returns with lower risk. This clearly indicates debt returns can be comfortably maximized by investing in high credit quality corporate bond funds and constant maturity gilt funds by adopting duration risk strategy and that there is no point taking in credit risk.

    What are the risks

    Theoretically, since the instruments in gilt funds are sovereign graded, there is no credit risk. Corporate bond funds are mandated to invest a minimum 80% in AA+ and above graded instruments, which are comparatively safer than credit risk funds. To further minimize risk in corporate bond funds, investors should select funds having portfolios with maximum allocation towards AAA and sovereign-graded instruments.

    Both these funds will carry duration risk, especially if the maturity profile of their overall portfolios are 5-10 years and above, which means returns of these funds can take a temporary hit during the interest rate hike cycles. The hit on the returns will be temporary and if investors stay invested for the entire maturity period of the fund, the duration risk can be minimized or avoided.

    Duration risk strategy

    Interest rates and bond prices are inversely related, so when interest rates fall in the economy, the demand for existing higher yielding bonds rises pushing their prices upwards. Due to the nature of long maturity profile funds and their higher modified durations, duration risk strategy works best when the interest rates are in their peak range, right before the interest rate cut cycle.

    To conclude, debt mutual fund returns will be cyclical in nature as per the interest rate cycles. Looking at the temporary cyclicality and volatility the long maturity profile funds faces, corporate bond funds having maturity profiles up to three-five years should be considered in an investor’s core portfolio. Higher maturity corporate bond funds and constant maturity gilt funds should be timed and considered as tactical bets.

    Currently the interest rate cut cycle has just begun and we may see more interest rate cuts in 2025 and 2026 to push growth in our economy. From 2024 till date, we saw long maturity profile funds delivering double-digit returns. The year 2024 was the right time for long maturity profile funds. Going ahead and looking at the yield scenario, investors should focus more on medium maturity corporate bond funds for better management of risk and returns.

    Rushabh Desai is founder of Rupee with Rushabh Investment Services



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