In an earlier post, I looked at how you can select a liquid fund. In this post, let’s look at how you can extend the same argument to selecting debt mutual funds for your portfolio. The pointers used in liquid funds can be extended to any debt fund. However, since we are looking at a much wider choice, there are a few additional aspects that must be considered.
In the case of debt mutual funds, the upside is capped (unlike equity funds). Therefore, it is important to understand the source of return (or extra return) that you earn in your debt mutual fund investments. In a debt fund, the source of return and risk is relatively easier to understand. Once you understand the source of risk in a debt fund and decide the extent of risk you are comfortable with, the choice of a debt fund shouldn’t be too difficult.
Let’s first look how a fund manager can generate an excess return (not on a risk-adjusted basis) for you.
What is the source of excess return in debt funds?
#1 Invest in Long Maturity Debt: Long maturity bonds are likely to offer a higher rate of interest (as compared to short-term bonds). Therefore, one way to increase your return from debt investments is to invest in long-term bonds (or long duration debt funds).
#2 Take Credit Risk: A company with good and stable financials should be able to issue debt at a lower rate (as compared to a company with poor financials). Why? Because it knows it carries lesser risk and wouldn’t want to pay more.
For instance, Reliance Industries can raise debt at a much lower rate as compared to a shoddy real estate company. From an investor point of view, investing in Reliance Industries bond will fetch lower returns than investing in bonds from a real estate company.
Now, consider this. A fund ABC that invests in high rated debt (say AAA rated paper) will likely offer inferior returns as compared to a fund XYZ fund that invests in A rated paper (so long as there are no defaults). If you focus only on the return and not on the source of the return, you will most likely choose Fund XYZ (without appreciating that it carries higher credit risk).
#3 Get the interest rate cycle right: Bond prices and interest rates move in opposite directions. When the interest rates go up, the bond prices go down and vice-versa. The extent of rise or fall in bond prices depends on the duration of the bond or debt portfolio.
Higher the duration, greater the interest rate sensitivity. A bond or bond portfolio with a duration of 10 will fall by 10% when the interest rates go up by 1% and rise by 10% when the interest rates go down by 1%. On the other hand, a bond or bond portfolio with a duration of 2 will fall by 2% when the rates go up by 1% and rise by 2% when the interest rates go down by 1%.
Longer the maturity of bond or bond portfolio, higher its duration.
If you knew that the interest rates will go down in the future, you will increase the duration of your bond portfolio. Similarly, if you expect the interest rates will go up, you will decrease the duration of your portfolio. By the way, this is easier said than done.
You can see points (1) and (3) run counter. You can see long maturity bonds give you scope for higher interest income. At the same time, such bonds or bond portfolio will have a higher interest rate sensitivity too.
#4 Market events could give rise to opportunities: There could be market-driven events. For instance, an adverse event could suddenly lead to lower prices (higher yields and higher potential returns). Sometimes, such opportunities are also due to the lack of liquidity in the bond markets in India. However, such opportunities should be few and far between. Don’t think a fund manager can rely solely on this kind of strategy.
#5 Keeping the costs low: A lower expense ratio directly adds to your returns. This is extremely important for debt funds where the scope to generate an extra return is not very high.
Things you must consider while selecting a debt mutual fund
#1 Are you comfortable with credit risk?
If you do not want to take credit risk, stick with a gilt fund (Government securities fund).
Do note, even though a gilt fund does not have any credit risk, it can still have interest rate risk. Unfortunately, post-SEBI rationalization of mutual fund schemes, there is no short-term gilt fund left. Most gilt funds are either gilt funds with a constant maturity of 10 years or funds with no restriction on maturity (the fund manager will adjust duration based on interest rate outlook).
There are alternatives that may provide Government bonds like security such as PSU bank debt funds. I presume the Government will step in and prevent PSU banks from defaulting. However, even the Government can’t prevent a credit downgrade. A credit downgrade (and not a full-fledged default) can lead to a fall in NAV.
#2 Are you comfortable with interest rate risk?
Personally, I am not very comfortable with interest rate risk. Interest rate upcycles and downcycles should cancel each other out and you have to be subject to unnecessary volatility.
It is a different matter if you want to benefit from interest rate movements.
If you can consistently get your interest rate outlook right, you can try to adjust portfolio duration accordingly i.e. increase portfolio duration when the interest rates or bond yields are likely to fall or decrease duration when the rate is about to rise. This is easier said than done. Even in such cases, tax implications will complicate matters for you. For others (and that includes me), stick with shorter duration short-term) bond funds.
#3 Dynamic bond funds may not be that dynamic
A dynamic bond fund should ideally adjust the duration of the portfolio depending on the interest rate outlook. If the interest rates are likely to increase, the fund manager should increase the duration of the bond portfolio. If the bond prices are expected to go up, the fund manager should decrease the portfolio duration.
The key is if fund managers can do this successfully on a consistent basis. The long-term performance of dynamic bond funds is nothing to speak off. The category performance is similar to that of lower duration funds. Do note these returns come with much higher volatility (as compared to lower duration funds). In my opinion, you can leave dynamic bond funds out from your portfolios.
#4 It is easier to trust Star ratings in the case of Equity funds
In case of equity funds, I am quite comfortable with Star ratings on ValueResearch or Morning Star. If the intent is not to chase the best equity fund (and just find a good fund), once you have zeroed in on the kind of fund you want for your portfolio (post asset allocation decisions), you can go with any good rated fund from the category. Even though we can refine the selection process further, you would still do quite fine with the aforementioned simple process.
This is not the case with debt funds.
Even the best rated long duration debt fund will perform poorly if the interest rates were to rise. I am sure many investors flocked to long term debt funds in late 2016 and early 2017 looking at 16-18% returns during the previous 2-3 years. The reason for such good returns was that the interest rates had gown down sharply during the time. Long term debt funds benefit from lower interest rates.
If you knew the reason behind such good returns in long term bond funds (which was not very difficult to figure out), you could have easily seen that the interest rates can’t keep going down for ever. Therefore, it was not smart to get into these kinds of funds at the time expecting a similarly high return.
This is not to say that you can easily figure out when the interest rates will start going up. Just that when the rates have been moving down for a few years, the odds of getting even lower rates may not be in your favour.
However, MorningStar and ValueResearch do provide Style Boxes, which can be quite useful.
For instance, ValueResearch provides StyleBox for the debt mutual funds.
Here is the Style for 2 Low Duration Funds.
As you can see, even though both are low duration funds, the fund on the right takes much lower credit risk. If you want to avoid credit risk, it is better to go with the fund on the right.
#5 Go with a bigger fund house and a bigger fund
I have discussed this aspect in my post on “How to select a liquid fund”. A bigger fund corpus should reduce concentration risk. Even if your fund portfolio were to experience a default, the hit on the NAV may not be very high. Similarly, a bigger fund house may have a greater reputation to salvage.
#6 A fund with a high expense ratio and category beating returns should be avoided
Yes, there are debt funds whose expense ratios would put many equity funds to shame. Since it is relatively easier to understand the source of risk in debt funds and excess return has a very clear element of risk involved, the fund (high expense ratio and high returns) may be taking an excess risk to generate very good returns for you. I wouldn’t be too comfortable with such funds.
#7 Have more debt funds than equity funds in your portfolio
Well, things do wrong. Irrespective of the amount of research you do, you may be in for negative surprises. In you have a few debt funds, you wouldn’t have to bear much brunt in the event of isolated defaults. However, even this wouldn’t save you from systemic issues.
Many investors have 3-5 equity mutual funds in their portfolios. Have at least as many, if not more, debt funds in your portfolio.
Many wouldn’t agree with this approach but this give me a lot of comfort.
How do I select a Debt Mutual Fund?
When you invest in equity funds, you expect it to be volatile all the time. The expectation with debt mutual funds is quite different. Many see it as a replacement for bank fixed deposits (that have no volatility). If you are such an investor and if you pick up a fund purely on the basis of the past returns and star ratings, you may be in for a negative surprise.
I think of debt funds as an instrument to lend stability (and lower volatility) to my portfolio. High duration (or high interest rate sensitivity) can be a great source of volatility in any debt fund portfolio. Therefore, I stay away from long duration funds.
I stick with liquid, ultra-short duration, low duration and money market funds. I pick these funds even for my long term goals (for the debt portion). These funds have very clear limitations on the interest rate risk they can take (through restrictions on portfolio duration).
The problem with aforesaid funds (liquid, ultra-short duration, short duration and money market funds) is that even though the level of interest rate risk is well defined, the credit strategy may not be very well defined.
To assess the level of credit risk, you can look at the scheme information document to see there is any restriction. From what I have seen, most Scheme Information Document are silent on this aspect or there is too much information to make any sense. AMCs are required to disclose portfolios on a monthly basis. This data is available on AMC websites. You can also look at their portfolios but that may be asking for too much. It is not practical either. Style Boxes on Value Research and Morning Star are good sources of information in this regard.
Here is what I would want to see in debt funds in my portfolio.
- Low Interest Rate Risk (You can stick to fund categories with lower duration)
- Low Credit Risk (Rely on Scheme information document, Style Boxes)
- Low Expense Ratio
- Bigger AMC
- Bigger Fund Corpus
Following the approach won’t eliminate adverse shocks to your debt portfolio. However, I would expect this to reduce the odds of such shocks and the impact of such shocks on your portfolio.
There is nothing wrong in taking the risk. At the same time, in my opinion, there is not much benefit in taking interest rate risk (unless the yield curve is quite steep). Interest rate upcycles and downcycles will cancel each other out. There may be merit in taking some credit risk. However, you must know that you are taking a risk and it may materialize.
In fact, for some of my clients, I have picked up funds with decent credit risk for that extra return kicker because they can afford to take such credit risk and are comfortable with such risk.
The trouble lies in trusting star ratings blindly and not appreciating the risk involved.