Q. I am a working professional with a stable income, I am in the highest tax bracket. I have been investing in Low-Duration Funds for the past 3 years, I now wish to diversify my debt mutual fund portfolio and invest in other categories of debt mutual funds. I am unable to decide between Corporate Bond Funds and Banking & PSU Funds. Can you elaborate on the major differences between the two categories and also tell me which category is more suited for risk-averse investors?
Meha Chandra, Bhagalpur, Bihar
Investment in debt mutual funds is a great investment option, especially for investors with a low-risk appetite. There are multiple avenues available to an individual in relation to investment in debt mutual funds such as Liquid Funds, Gilt funds, Short Duration Funds, etc. However, Corporate Bond Funds and Banking and PSU Funds are two of the most popular categories.
Both options have their strengths and weaknesses. In the case of investment in Banking & PSU Mutual Funds, 80% of the corpus of the mutual fund is invested in debt instruments issued by banks, Public Sector Units (PSUs), and Public Financial Institutions (PFIs). In the case of investment in Corporate Bond Mutual Funds, 80% of the corpus of the mutual funds is invested in bonds and debentures with high credit ratings, i.e., bonds or non-convertible debentures having a rating of AA+ or above. Below, we analyse the major differences between the two options:
Risk Matrix
In the case of Banking & PSU Mutual Funds, your money is invested primarily in bonds and debentures issued by government-owned companies (PSU and PFIs) or in banks or municipal bonds. In all these cases there is minimal risk of default. The central government and state governments keep a strict check on the financial health of the PSUs, and PFIs and inject capital into them from time to time. Even if a particular PSU/PFI is not performing well, there is very little possibility of it defaulting, since the central government/state government typically steps in order to ensure that credit commitments are honoured.
Similarly, the risk associated with debentures and bonds issued by banks is also very low, banks are regulated by the Reserve Bank of India, and typically have high capitalization levels, since it is a regulatory requirement, the possibility of a bank default on its debt commitment is extremely low. Municipal bonds are generally guaranteed by the state governments, in case of a liquidity crunch the state government steps in to ensure that there is no default on repayment of principal and interest.
In the case of Corporate Bond Mutual Funds, 80% of the corpus is invested into debt instruments that have a high credit rating of AA+ and above. Credit rating is akin to the credit score of individuals, in the case of credit ratings an independent third party (credit rating agency) evaluates the creditworthiness of the company issuing debt securities examples of credit rating agencies are CRISIL, ICRA, CARE, etc. Corporate Bonds Mutual Funds are considered amongst the safest mutual funds since they invest 80% of their corpus into debt instruments having a high credit rating.
Investment Target
Banking & PSU Mutual Funds are mandated under law to invest at least 80% of their corpus into debt securities issued by (a) banks, (b) PFIs, (c) PSUs and (d) Municipal Bonds. It is important to note that these funds can invest the remaining 20% in securities of any kind of company and not only in securities issued by banks, PFIs, and PSUs.
Corporate Bond Mutual Funds’ investments are not limited to any particular kind of company. They are free to invest in any category of company.
Returns
Investments in mutual funds do not offer guaranteed returns irrespective of the quality of the investment made by the mutual fund. Historically, the top 5 Banking and PSU Mutual Funds have provided a return above 7% (5 Year CAGR, data collected as on 7 August, 2022).
Corporate Bond Mutual Funds are not far behind, historically, the top 5 Corporate Bond Mutual Funds have provided a return above 6.5% (5 Year CAGR, data collected as on 7 August, 2022).
It is important to note that past returns are not a guarantee for future returns.
Expense Ratio
The majority of Banking & PSU Funds, as well as Corporate Bond Funds, are actively managed as a result the expense ratio associated with these mutual funds is higher than the expense ratio charged by passive mutual funds such as index mutual funds. However, it is important to note that the majority of index mutual funds are equity mutual funds and from the perspective of risk management are a completely different financial product than debt mutual funds.
Lock-in
Both, Corporate Bond Mutual Funds and Banking and PSU Funds are open-ended mutual fund schemes. Typically, investment in these funds does not involve any lock-in period and investors can withdraw funds anytime.
Liquidity
As stated previously, typically Corporate Bond Mutual Funds and Banking and PSU Funds do not have any lock-in period. Separately, since the majority of the investment in these funds is made in debt instruments, their returns historically have been more stable than that of equity funds. Consequently, both categories of mutual funds provide ample amounts of liquidity.
Tax Efficiency
Both, Corporate Bond Funds and Banking and PSU Funds are debt mutual funds and are taxed accordingly. Short-term capital gains in the case of debt mutual funds are taxed based on the applicable tax slab of the investor, i.e., for ex. if you are in the highest tax bracket your short-term capital gains will be taxed at the rate of 30 percent. Long-term capital gains are taxed at the rate of 20 percent with indexation benefits.
Conclusion
Banking and PSU Funds as well as Corporate Bond Funds are two sub-categories of debt mutual funds which have the potential to offer reasonable returns without exposing the investor to a high amount of risk. Both categories of mutual funds are tailored for investors who have a low-risk appetite. One can consider investing in either of the two after considering the parameters listed above and after reading the offer document in detail.
Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.
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