Should investors look at Banking and PSU funds

What are Banking and PSU Funds

One of the most popular categories of debt funds in India is the Banking and PSU debt fund. These funds primarily invest in bonds issued by banks and public sector undertakings (PSUs), offering moderate risk exposure. While interest rate risk remains a factor, these funds are considered very low on default risk, making them a relatively safe investment option. The table below highlights the top 10 Banking and PSU debt funds in India based on their CAGR returns since launch. The median returns of these top-performing funds stand around 8%.

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In the last few years, these Banking and PSU funds have not been too popular due to the relatively lower returns. In fact, these Banking and PSU funds currently manage around Rs79,200 crore. But the time may be ripe for investors to again look at these funds. Let us find out why.

Table of Contents

1. What are Banking and PSU Funds
2. How Banking and PSU Funds Invest?
3. Why is there a case for Banking and PSU Funds?
4. Why to bet on Falling interest rates?
5. How Banking and PSU Funds will ride the Yield Curve

How Banking and PSU Funds Invest?

Here’s how a typical Banking and PSU debt fund allocates its investments across various debt instruments. These funds are primarily pure debt funds with a focus on short to medium-term bonds from banks and public sector undertakings (PSUs), typically with maturities of 3 to 5 years.

Banking and PSU funds typically invest about 80% of the corpus in bonds issued by banks and public sector undertakings, with the remaining 20% allocated to low-risk G-Secs or government-backed mutual funds. This ensures a stable and secure portfolio for investors.

The primary focus of these funds is credit quality, which is why the assets held by these funds tend to have superior credit ratings compared to other debt funds. These funds focus mainly on top-rated debt instruments, and they rarely venture down the yield curve. By sticking to AAA-rated bonds, they offer some of the safe investment options in India with minimal default risk.

These funds maintain an optimal balance between liquidity, safety, and yield. One of the popular strategies followed by Banking and PSU funds is riding the yield curve, where they buy longer-duration bonds to benefit from potential capital appreciation.

Around 80-85% of their investments are typically in AAA bonds from banks and PSU companies, with the balance invested in sovereign bonds or other high-credit quality bonds, making them an attractive choice for conservative investors.

As we look towards 2025, some of the best PSU funds 2025 are expected to focus on this strategy, offering a strong public sector fund performance. While comparing banking funds vs equity funds, these debt funds provide steady returns with relatively lower risk, making them a preferred choice for conservative investors.

Why is there a case for Banking and PSU Funds?

The Banking and PSU fund is a pure debt fund that invests in high-quality bonds issued by Indian banks and PSUs, typically allocating 80-85% of its portfolio to AAA-rated bonds with the balance in government securities. This makes the default risk low while providing stable returns. With interest rates expected to peak, investing in these PSU bond funds becomes an attractive strategy, as they lock in higher yields in quality debt products.

The RBI hiked rates by 250 basis points between May 2022 and February 2023, but has since held rates steady, raising hopes that they will soon start to decline. A fall in interest rates would benefit these funds, as bond prices rise inversely to yields, leading to potential capital gains. This strategy is one of the safe investment options in India, ensuring low default risk while taking advantage of market conditions.

Looking ahead, the best PSU funds 2025 are expected to perform well, driven by these trends. Compared to banking funds vs equity funds, banking sector mutual funds offer more stability and lower risk, making them a preferred choice for conservative investors seeking steady returns.

Why to bet on Falling interest rates?

Investing in bond funds at current yields offers 2 advantages. Firstly, it locks in relatively higher yields ensuring a boost to YTM. Secondly, it also generates capital gains as the yields fall over time. Effective the bet is on falling bond yields, and here is why.

1. CPI Inflation has shown genuine signs of normalizing. Retail inflation is a key driver of bond yields and a series of rate hikes by RBI has brought down the inflation. There may be spikes but the journey is headed down. The target is 4% and not too far off.
   
    
2. A major driver of inflation in India has been oil. While Brent Crude has risen from $70/bbl to $90/bbl, most of the risks, including geopolitical risks, may already be in the price. Hence, further upsides to oil prices look unlikely.
   
    
3. Apart from falling yields benefiting bond prices, the normalization of yield curve also gives opportunities. Today, 3 years and 5 years yields are equal to or higher than 10 year yields and that has to normalize. That will also benefit the fund.

The fund leverages locking higher yields and also plays on falling yields. In addition, the mean reversion of yield curve is icing on the cake.

How Banking and PSU Funds will ride the Yield Curve

Here is what riding the yield curve entails. It is about buying a long-term bond with a maturity longer than investment horizon. A 3 year maturity fund buying a 5 year bond is a case in point. This 5 year bond will be sold at the end of the 3 year time horizon and due to falling rates, the capital gains will be booked. In addition, bond with longer duration gain more from a fall in yields. This strategy is profitable if rates fall or yield curve normalizes and both look likely going ahead.