By now, most investors understand the range of instruments available to equity mutual funds. But debt mutual fund portfolios can still present a puzzle.
While most investors may be aware of vanilla options such as government securities, corporate bonds, commercial paper and treasury bills, there are also some exotic mentions in debt mutual fund portfolios. Here we attempt to explain four debt securities held by mutual funds that are relatively unknown to retail investors.
Tri-Party Repo (TREPs)
Simply put, repo or repurchase agreements are short-term borrowing tools where securities are sold with an agreement to repurchase them later. Mutual funds participate by lending capital to borrowers against collateral, with agreements to repurchase at predetermined rates and dates. The primary borrowers include banks, primary dealers, and other financial institutions. The underlying collateral typically comprises treasury bills, government securities, and state government securities, rendering these transactions virtually credit risk-free.
The Clearing Corporation of India Ltd (CCIL) operates two anonymous order matching platforms for market repos in government securities: Tri-Party Repo (TREPs) and Clearcorp Repo Order Matching System (CROMS). TREPs replaced the Collateral Borrowing and Lending Obligation (CBLO) system in November 2018.
TREPs are among the most liquid and secure components of debt fund portfolios. The distinguishing characteristic of TREPs is that CCIL, acting as a third party, manages collateral throughout the transaction lifecycle, automatically handling selection, valuation, and substitution. Conversely, in CROMS, participating parties directly negotiate and manage their collateral arrangements.
Mutual funds also engage in traditional bilateral repo systems independently where corporate bonds also serve as underlying securities.
TREPs yields generally correlate with the RBI’s repo rate and prevailing short-term interest rates, providing modest and stable returns. Investment tenures span from overnight to several days, making them particularly suitable for short-term liquidity management. Overnight funds and liquid funds constitute the primary categories with substantial TREPs investments for income generation, while other mutual fund categories utilise TREPs for cash management and portfolio liquidity maintenance.
Pass-Through Certificates
Pass-Through Certificates (PTCs) represent securitised debt instruments issued mostly by banks, non-banking finance companies, and housing finance companies. These instruments reflect pooled loans where investors such as mutual funds, receive portions of cash flows generated by underlying loans including interest and principal payments. PTCs are backed by assets such as home loans, auto loans, microfinance loans, or commercial loans. This structure enables banks and financial institutions to free up capital for new lending, improve return on equity, and maintain adequate capital ratios while expanding loan portfolios more efficiently.
The risk characteristics of PTCs vary considerably based on underlying asset quality, with home loan-backed PTCs generally considered safer than those supported by commercial loans or microfinance portfolios. Returns typically exceed government securities but incorporate credit risk associated with underlying borrowers. PTCs generally feature tenures ranging from one to ten years, depending on the underlying asset pool. According to recent portfolio data as of June 2025, 95 schemes from major fund houses across most categories invested approximately ₹21,242 crore in AAA, AA+, and AA-rated PTC instruments.
For example, ICICI Pru Banking & PSU Debt Fund invested approximately ₹24 crore in India Universal Trusts AL2 SR-A-1, originated by HDFC bank and backed by the bank’s car loan portfolio.
Interest Rate Swaps
Interest rate swaps are derivative contracts where two parties exchange interest rate cash flows, swapping fixed-rate payments for floating-rate ones or vice versa. Debt mutual funds use these primarily to hedge interest rate risk and as a tool to enhance returns in a rising rate environment. Major participants include banks, financial institutions, and large corporations. These contracts can range from one year to several years, allowing long-term risk management.
Due to limited issuance of floating rate bonds in India, funds in the floating rate bond category use interest rate swaps to meet the 65 per cent regulatory requirement. Fund managers enter swap contracts to convert fixed-interest securities into floating-rate instruments, using IRS to manage interest-rate risk effectively.
For example, a fund manager holding a 5 per cent fixed-rate bond expects interest rates to rise, which would normally reduce bond value and NAV. To hedge this, she enters into an IRS deal with a bank, agreeing to pay 4 per cent annually while receiving a floating rate of MIBOR + 100 basis points.
As rates rise, MIBOR increases, boosting the floating interest income. Without the swap, the fixed bond’s value would fall, impacting returns. Through IRS, she effectively transforms her holding into a floating-rate bond, preserving or enhancing NAV in a rising rate cycle.
Additional Tier 1 Bonds
In India’s banking sector, bonds are categorised into distinct tiers based on risk profiles and regulatory treatment under Basel III norms. Additional Tier 1 bonds, also known as perpetual bonds or contingent convertible bonds, represent unique debt instruments with equity characteristics. These bonds offer attractive yields, typically 200-400 basis points above government securities, but carry substantial risks. The primary risk involves potential write-down of capital or skipped interest payouts when the issuing bank’s capital ratio falls below regulatory thresholds. AT1 bonds are perpetual instruments with no fixed maturity, and banks can skip coupon payments without this being treated as default. However, they typically offer a call option to the issuer.
Recent regulatory actions, including the Reserve Bank of India’s interventions with Yes Bank, demonstrated how AT1 bondholders can face complete capital loss. This risk was underscored in March 2020 when Yes Bank’s financial difficulties led to ₹2,800 crore worth of AT1 bonds held by 30 mutual fund schemes being written off entirely. Following the Yes Bank incident, mutual funds have substantially reduced their AT1 bond holdings. However, a few schemes continue to hold these bonds issued by major banking institutions.
Published on July 19, 2025
