Should investors look at Banking and PSU funds

What are Banking and PSU Funds

One of the very popular categories of debt funds in India is the Banking and PSU Funds. These are debt mutual funds that invest predominantly in the bonds issued by the banks and public sector undertakings (PSUs). These funds are treated as moderate risk funds. While the interest rate risk is still there, these funds are very low on default risk. The table below captures the top 10 Banking and PSU funds in India in terms of CAGR returns since launch. The median returns of the top 10 funds are around 8%.

Data Source: AMFI

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.

How Banking and PSU Funds invest

Here is how a typical banking and PSU fund invests its money across debt instruments. Remember it is primarily a pure debt fund.

• The Banking and PSU funds are short to medium term funds that invest in bonds of banks and public sector undertakings (PSUs) for 3 to 5 years maturity.
  
   
• These funds would normally invest about 80% of the corpus in debt instruments issued by banks and public sector undertakings, with other 20% in low risk G-Secs.
  
   
• Credit quality is the main focus of this fund. Hence, the assets held by these Banking and PSU Funds have superior credit quality compared to other debt funds and they further minimize the risk by focusing more on top-rated debt instruments only. They rarely go down the yield quality curve.
  
   
• Banking and PSU funds maintain an optimum balance between liquidity, safety, and yield. One of the popular strategies followed by Banking and PSU funds is riding the yield curve; which buys longer duration bonds to gain from capital appreciation.

Banking and PSU Funds invest close to 80-85% in AAA bonds of banks and PSU companies. The balance is invested in either sovereign bonds or other high credit quality bonds.

Why is there a case for Banking and PSU Funds

The Banking and PSU Fund is a pure debt fund, that invests in the bonds issued by Indian banks and other PSUs. Typically, a Banking and PSU fund in India would have about 80-85% of its portfolio in such triple AAA rated bonds of banks and PSUs with the balance in government securities. Hence default risk in the overall portfolio is quite low. Currently, the big bet in favour of the Banking and PSU Funds is that the interest rates should peak. A good strategy to play this trend would be to invest in debt instruments issued by banks and PSUs. Such funds invest in high quality bonds issued by government companies which have a moderate risk profile but is able to successfully lock in the current higher yields.

The RBI has already hiked repo rates by 250 basis points from 4.00% to 6.50%, between May 2022 and February 2023. However, since February 2023, the RBI has held status quo on rates. This raises the hope that rates should touch a top soon and then start to move lower. That would be a double benefit. It helps investors to lock into higher yields in quality debt products and at the same time, it benefits from falling yields as bond prices will rise. In the case of bonds, the bond prices are inversely related to the bond yields and a fall in yields means a spike in bond prices, leading to capital gains. This strategy will ensure interest rate risks work in favour of the fund, even as the default risk is kept at subdued levels.

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.