Banking & PSU debt mutual funds: Good returns combined with safety

High-quality debt holdings ensure that these funds do not go into a tailspin due to credit defaults.

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These mutual funds mostly invest in a mix of bonds issued by banking firms and PSUs.
Debt fund investors usually seek slightly better returns than bank fixed deposits for their immediate needs. However, if this higher return comes at the cost of safety of capital, then it makes no sense. Recently too many bad apples have emerged among debt funds, souring the experience for investors.

Even funds from supposedly safer categories like liquid and ultra-short term have taken a hit. However, one category of debt funds has quietly emerged as a safe hiding place. So are banking & PSU funds the answer to investor woes?

Standing tall

These funds were introduced as a separate category last year during the fund classification exercise. However, many of the existing funds in this space have been around for longer. Earlier classified as short-term or income funds, these were rechristened as banking & PSU funds.

As the name suggests, these funds mostly invest in a mix of bonds or debentures issued by banking firms and public sector enterprises including public financial institutions. The portfolio is, therefore, inherently made of the highest credit quality. Bonds or debentures of most PSUs boast the highest credit rating as these are owned by the government of India and enjoy quasi-sovereign status as borrowers.

Some of the prominent PSUs in fund portfolios are National Highways Authority of India, Food Corporation of India, Rural Electrification Corp, NTPC, Power Finance Corp, SIDBI and NABARD, among others. “Most PSUs tend to be rated AAA or equivalent even if the balance sheet may not be of commensurate strength as the government ownership lends a degree of comfort about repayment,” points out Arvind Chari, Head – Fixed Income, Quantum Mutual Fund.

Bonds or debentures of banking entities are rated AAA or AA depending on the tenure. However, these are also of impeccable credit quality. While banking and PSU funds can invest up to 20% of the portfolio in other instruments, many have veered towards government bonds in recent times rather than looking for higher yield with lower quality corporate bonds.

Good returns combined with safety
Many of these funds have given double digit returns in past one year
Fund Net assets (Rs Cr) 1 year return (%) Average maturity (yrs)
Kotak Banking and PSU 1,617 10.1 4.61
Aditya Birla Sun Life Banking & PSU 6,459 9.54 4.23
ICICI Prudential Banking & PSU 5,612 8.67 3.8
IDFC Banking & PSU 6,126 10.58 3.7
Reliance Banking & PSU 3,934 9.51 3.52
SBI Banking and PSU Fund 1,746 8.83 3.36
DSP Banking & PSU 1,763 9.16 3.34
Axis Banking & PSU 6,451 10.01 2.8
HDFC Banking and PSU 3,123 9.37 2.68
Sundaram Banking & PSU 1,013 9.53 1.96
Above list includes funds with corpus greater than Rs 1,000 cr only. Source: Value Research. Data as on 28 June

With such a high credit quality, banking and PSU funds have remained resilient even as others have taken hits from recent credit episodes. “With an inherently high quality portfolio, banking and PSU funds are being seen as a safe haven in a turbulent bond market,” says R. Sivakumar, Head of Fixed Income, Axis Mutual Fund.

Apart from the favourable credit positioning, banking and PSU funds also score high on the liquidity front. The bonds and debentures of PSUs and banks boast high liquidity in the secondary market. Given that these are well traded, fund managers can easily buy and sell these bonds to capture pricing opportunities. These opportunities arise from playing with the portfolio duration— fund managers switch between shortterm and long-term maturity bonds depending on the interest rate scenario.

In a falling interest rate scenario like last year, these bonds can provide significant capital appreciation. Dhawal Dalal, CIO, Fixed Income, Edelweiss Mutual Fund, says most banking and PSU funds have benefited from softening yields by positioning the portfolio towards mediumterm to long-term bonds.

These funds have certainly stood out on the performance front. Over the past year,these funds have clocked nearly 9% returns. This is only behind gilt funds and long duration funds which benefited the most from the down-trending interest rates. Over the past three and five years, these funds have delivered a healthy 7.5% and 8%, respectively—far better than most other debt fund categories. These have also exhibited low volatility in return across time periods.

De-risk the portfolio
So should investors consider banking and PSU funds amid the stress in the bond market? The focus on high credit quality, short-to-medium maturities and inherent high liquidity make these funds attractive for debt fund investors, say experts. These fit the needs of an investor looking for higher returns than bank FDs, without taking added risk. Sivakumar says this is a good option for risk-averse investors. “Debt fund investors can de-risk the portfolio by parking some money in these funds,” he says.

Dalal says the turmoil in the credit market is likely to persist for some time. “We expect more rating downgrades. In this scenario, investors will find comfort in banking and PSU funds with their exposure to high quality bonds and relatively liquid assets.

Given that further interest rate cuts are likely in the medium-term, these funds with higher portfolio duration are likely to do better,” he says. However, investors looking to avoid interest rate risk should pick funds with lower duration or average maturity. Chari adds the prevailing spreads (difference in yield between two bonds) for AAA-rated PSU bonds over government securities provide for attractive yields across maturities.
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