Banking & PSU Debt Funds will not help you avoid credit problems!

Published on / By M. Pattabiraman Twitter: @pattufreefincal / 1 Comment

Published: July 18, 2019 at 10:51 am

Last Updated on December 29, 2021 at 1:00 pm

Are Banking & PSU Debt Funds a safe alternative for investors who wish to get higher returns than liquid funds and overnight funds? With so many credit defaults events in the debt mutual fund space, this a natural question to ask. Let us find out.

The first step is to ask, “what is a safe investment?”. Does this mean the NAV keeps increasing every day by pretty much the same amount and there are no sudden up or down movements? Or, does it mean, there is no vertical drop in NAV due to a change in a credit rating or an outright default? Or does it mean, the fund will provide a return close to what you expect in spite of daily fluctuations?

If those are your expectations from Banking & PSU Debt Funds or from any mutual fund for that matter, then you are likely to be disappointed. When it comes to investment risk, you can run, but you cannot hide.

What are Banking & PSU Debt Funds?

An open-ended debt scheme that predominantly (min 80%) invests in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions. On the face of it, this seems like a narrow investment mandate. It is not.
Such debt funds can invest in bonds of any duration and therefore are typically subject to interest rate risk. This means that the NAV will react to the demand and supply of similar bonds in the market. There is no restriction on credit quality as well.
Investors assume such “banking and PSU fund” can only invest in AAA bond. In a la la land perhaps, not in the real world. Even if they invest only in AAA bonds, why are you so sure it will not become AA and why are you sure that the fund manager will/can sell such bonds and replace them with AAA bonds?
Such reactions can mean a significant up or down movement over the course of a few weeks of sideways movement over the course of months. This means that returns can fluctuate … a lot. If you are new to debt funds, you can download an e-book on understanding debt funds (pus six other free ebooks). Or in particular, check out: Understanding Interest Rate Risk in Debt Mutual Funds
Such funds will also react to oil price movements as mentioned in a May 2019 post. For example see:
Axis Banking & PSU Debt Fund For the remainder of this article, I shall give you exmaples of how banking and psu debt funds are not immune to credit problems. Take for exmaple this July 2017 Moodys report where they downgraded deposits of
(1) Bank of Baroda (BOB), (2) Bank of India (BOI), (3) Canara Bank (Canara), (4) Oriental Bank of Commerce (OBC), (5) Punjab National Bank (PNB), (6) Syndicate Bank (Syndicate) and (7) Union Bank of India (Union Bank)
So what you think would have happened to the NAV of funds that held bonds from these banks?

And who said PSUs cannot get into credit trouble? Uttar Pradesh Power Corporation bonds (2021) are AA rated. If a state PSU does not get a AAA, it could go down to A too at some point in time. Please recognise, you can lose money if AAA becomes AA. An outright default is not necessary.

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Let us take a peep into the current portfolio of funds in the banking and PSU category (source VR).

HDFC Banking and PSU Debt Fund (AUM ~ 3187 Crores): 17.45% of AA bonds, 11.63% A rated and below bonds (most of them banks as above). This fund got into credit trouble in Jan 2019 for holding bonds associated with IL&FS. These were special purpose vehicles which ironically are meant to shield the subsidiary from the parents financial troubles!

Franklin India Banking & PSU Debt Fund (AUM ~ 212 Crores): 21.4% AA bonds.

Kotak Banking and PSU Debt Fund (Oldest such fund? AUM 1790 Crores): 21.47 AA rated bonds.

I could go on, but it is boring. I hope the message is clear enough. You cannot escape from any kind of risk by choosing banking and PSU debt funds over other categories. The credit risk is perhaps a bit lower than corporate bond funds or credit risk funds but not low enough for you to sleep peacefully. Stop taking every newspaper headline seriously! Did deeper once and you will never read such news again.