Banking and PSU Debt Funds: Safety, Yield and Rules
A banking and PSU debt fund is a SEBI defined category that must invest at least 80 percent of its assets in debt instruments issued by banks, public sector undertakings, public financial institutions and municipal bonds. The remaining 20 percent gives the manager room for government securities, other corporate bonds or cash.
The category exists to give investors high credit quality without going all the way to a pure gilt fund. In practice these portfolios hold bank certificates of deposit, bonds of large PSUs, paper from institutions such as refinance and power sector lenders, and central government securities.
What the category does not fix is interest rate risk, and that is where most investors get surprised.
What the 80 percent rule covers
The eligible issuer list is narrow and specific. Banks, public sector undertakings, public financial institutions, and municipal bonds, which SEBI added to the permitted set to support urban local body borrowing. A private manufacturing company’s bond does not qualify inside the 80 percent bucket, though it could sit in the flexible portion.
There is no duration mandate in this category. That is important. Two banking and PSU funds can both follow the rule while one runs an average maturity of two years and the other runs five. Their behaviour in a rate move will be completely different, so read the factsheet rather than trusting the label.
The perpetual bond footnote
Some bank issuance takes the form of additional tier 1 perpetual bonds, which have no fixed maturity and can be written down by the regulator if the bank hits stress. The 2020 write down at Yes Bank made this concrete for Indian investors. SEBI subsequently capped how much of a debt scheme’s assets can sit in such instruments, with a lower sub limit per issuer, and prescribed how their maturity should be treated for valuation. Check the scheme’s disclosure if this matters to you.
The misconception worth correcting
Banking and PSU does not mean government guaranteed. A PSU bond is a corporate obligation of that company. Sovereign ownership usually implies strong support and these issuers have a very good track record, but the government does not stand behind every PSU bond as a legal guarantee the way it stands behind a government security.
The second half of the misconception is that high credit quality removes volatility. It does not. A AAA rated five year bond still loses price when yields rise. Credit quality protects you from default, not from mark to market movement.
Where the risk actually sits
- Interest rate risk: the dominant risk. A fund with modified duration of 3 loses roughly 3 percent of NAV if yields rise by 100 basis points, before accrual offsets some of it.
- Spread risk: in stressed markets the gap between PSU bond yields and government security yields widens, hitting prices even with no rating change.
- Liquidity risk: some PSU paper trades thinly. SEBI requires open ended debt schemes other than overnight and gilt schemes to hold a minimum share of assets in liquid instruments such as cash, government securities, treasury bills and repo on government securities, which cushions redemption pressure.
How it compares with neighbouring categories
| Category | SEBI rule | Credit risk | Rate risk |
|---|---|---|---|
| Banking and PSU | Minimum 80 percent in bank, PSU, PFI and municipal debt | Low | Depends on the fund, no duration cap |
| Corporate bond | Minimum 80 percent in the highest rated corporate bonds | Low to moderate | Depends on the fund |
| Credit risk | Minimum 65 percent in below highest rated corporate bonds | High | Moderate |
| Gilt | Minimum 80 percent in government securities | Sovereign | Usually high |
Choosing and holding one
Start with the potential risk class matrix that every debt scheme must publish. It places the scheme in a grid cell for maximum credit risk and maximum interest rate risk, which is a faster read than the full portfolio. Then look at modified duration, the rating breakup, the top ten issuers and the expense ratio.
Cost matters more here than in equity funds. If the portfolio yield is around 7 percent, a regular plan charging 0.9 percent hands over a large slice of it. Match your holding period roughly to the fund’s duration too, so accrual has time to absorb an adverse rate move.
Tax treatment is that of a debt scheme. The rules for schemes investing predominantly in debt and money market instruments were rewritten from April 2023 and adjusted afterwards, so verify the current provisions of the Income Tax Act before you redeem.
Frequently Asked Questions
Are banking and PSU funds safer than fixed deposits?
They are different, not strictly safer. A bank deposit up to the DICGC insured limit has explicit cover and a fixed contracted rate. A banking and PSU fund has no capital protection and its NAV moves daily, but it offers better liquidity and potentially better post tax outcomes depending on your slab.
Can a banking and PSU fund lose money in a year?
Yes, and it has happened during sharp rate rises. If yields jump and the fund carries meaningful duration, the price loss can exceed the accrual earned over a few months. Over a holding period matching the duration, the odds improve considerably.
Do these funds hold municipal bonds in practice?
Municipal bonds are permitted inside the 80 percent bucket, but the Indian municipal bond market is still small, so allocations tend to be minor. Check the portfolio disclosure if you want to know a specific fund’s exposure.
How is this different from a corporate bond fund?
Corporate bond funds must hold at least 80 percent in the highest rated corporate paper, which includes private issuers. Banking and PSU funds restrict the issuer type instead of only the rating, which usually means more government linked names.
Key Takeaways
- SEBI requires at least 80 percent in debt of banks, PSUs, public financial institutions and municipal bonds.
- There is no duration limit in the category, so rate risk varies widely between funds.
- PSU paper is not government guaranteed, and high credit quality does not remove price volatility.
- Perpetual bank bonds carry write down risk and sit under SEBI exposure caps.
- Match your holding period to the fund’s modified duration and prefer low cost direct plans.
