Listen to this article
Diversification in investing is the key to mitigating market volatility and reducing portfolio risk thereby ensuring stable returns over time. As Sir John Templeton rightly mentioned, “The only investors who shouldn't diversify are those who are right 100% of the time.”.
A balanced asset allocation in a portfolio can smooth out the inevitable dips and bumps due to changes in market conditions and thereby averting significant losses. The primary objective of designing a balanced portfolio is to avoid over-concentration in a single asset class while taking into account the investor’s preference for risk tolerance.
In investing, asset classes are broadly divided into equity, debt, and cash. However, diversification can happen across asset classes or within an asset class. In debt investing, diversification can include different types of debt instruments and funds.
A balanced portfolio in debt investing can be designed as per the maturity, credit risk, and risk preference of investors. At a granular level, it can include direct exposure to government securities, corporate bonds, commercial papers, etc., or indirect exposure to such securities via different types of debt funds.
Debt alternative investment funds (AIFs), which fall under Category II of SEBI Regulations for AIFs, 2012, invest in debt / debt instruments of listed as well as unlisted companies. They can invest in a diverse range of debt securities, including corporate bonds, non-convertible debentures, commercial papers, government securities, and other fixed-income instruments. Investments made by debt AIFs are governed by the fund's investment strategy and risk-return spectrum with the objective of providing income to the investors.
In general, debt funds face three types of risks:
Interest Rate / Duration Risk: Interest rate risk occurs due to changes in market interest rates. When interest rates decline, the demand for debt securities issued at higher coupon rates goes up resulting in higher valuation of debt securities. Conversely, when interest rates rise, demand for securities issued at lower coupon rates goes down reducing the valuation of securities. This inverse relationship between interest rates and security prices results in interest rate risk. Further, the impact of changes in interest rates depends on the remaining maturity of debt securities. In general, bonds with longer duration are more sensitive to changes in interest rates than the same with short duration.
Liquidity Risk: Liquidity risk refers to the risk of inability to liquidate the investments at fair value before maturity. This type of risk is applicable to debt funds which are open-ended in nature.
Credit / Default Risk: Credit risk refers to the risk of default by the issuer of fixed-income securities in the fund. This happens when the issuer entities are unable to make repayments on time.
Unlike common debt mutual funds in the market, debt AIFs being close-ended in nature, do not carry mark-to-market (MTM) or interest rate risk nor do they face liquidity risk because investors can’t redeem their investments before maturity (they can transfer their units to other investors via a straightforward transfer document in a secondary transaction).
Hence, the primary risk faced by debt alternatives is credit risk, which makes them an ideal investment vehicle to diversify your portfolio. However, choosing a highly professional fund manager with deep local expertise, excellent sourcing ability, and a dedicated risk management team ensuring tight monitoring is highly useful in such cases to ensure minimization of losses due to credit risk. Regulatory steps like the enactment of the Insolvency and Bankruptcy Code and the introduction of the Account Aggregator framework also brought confidence in the market and enabled transparency and scope for efficient decision-making about borrowing entities.
These apart, the Finance Act 2023 provided the long-awaited level playing field to all debt asset managers of various pooled investment vehicles by putting an end to indexation benefit for incremental debt MF investments. This enabled the investors to make decisions about their portfolio allocation within debt purely based on the risk-reward spectrum and asset manager’s track record rather than post-tax returns.
