Can I use Banking & PSU debt funds instead of gilt funds?

Published: April 21, 2021 at 12:15 pm

Shushanth asks, “dear Pattu Sir, thank you for the recent articles about gilt mutual funds, but I think they are too volatile for me. Can I use banking and PSU funds instead of gilt funds for long-term goals?” The underlying assumption here seems that Banking and PSU debt funds are “safe” and less volatile than gilt funds.

The logic of clubbing bank bonds and PSU bonds in the same portfolio was probably because of a perceived notion of “safety”. Before the SEBI MF categorization rules, a few funds were exclusively investing in such bonds. Now the official definition of such fund is “open-ended debt schemes predominantly investing (80%) in debt instruments of banks, Public Sector Undertakings, Public Financial Institutions”.

Are Banking and PSU debt funds less volatile than gilt funds? Not really! The standard deviation of 17 banking and PSU funds ranges from  1.78% to 4.77% over the last three years. The corresponding number for 25 gilt funds (excluding 10Y constant maturity debt funds) range from 2.97% to 4.49%.

What does this mean? Banking and PSU bonds are also subject to duration risk or demand-supply risk, or interest rate risk and the typical quantum of NAV fluctuations are comparable to gilt funds.

Banking and PSU funds are not as safe as gilt funds but are they “reasonably safe”?  A look at the April 2021 Debt fund screener gives the following output:


Scheme NameAA / AA+ / AA-
ICICI Pru Banking & PSU Debt Fund19.16
HDFC Banking and PSU Debt Fund16.81
TRUSTMF Banking & PSU Debt Fund13.39
Kotak Banking and PSU Debt Fund12.84
Tata Banking & PSU Debt Fund9.57
PGIM India Banking & PSU Debt Fund8.27
SBI Banking and PSU Fund6.21
Aditya Birla SL Banking & PSU Debt3.37
L&T Banking and PSU Debt Fund3.13
Franklin India Banking & PSU Debt Fund1.04

And there is a small default exposure too.

Scheme NameD
HDFC Banking and PSU Debt Fund0.04
UTI Banking & PSU Debt Fund3.66

Even if you assume a less than AAA-rated PSU bond is not a problem, the govt will come to the rescue, you cannot say the same about banks, and it is not hard to find a AA rated bank bond.

So not only are banking and PSU bond funds just as volatile, the possibility of credit risk (changes in rating) and credit events (a default) is distinctly non-zero.

So are you getting lesser NAV fluctuation via Banking and PSU funds when compared to gilt funds? At the category level, this is not distinct enough.  The reason for this is the average maturity period of the portfolio. As of March 2021, it ranges from 0.35 years to 8.75 years! Sadly the situation at the category level is the same for corporate bonds funds which should invest 80% of the portfolio in AA+ or higher rated bonds.

If you can spot a Banking and PSU fund that has a history of investing in short-term bonds (say not more than 3 years) and will continue to do so with high credit quality the yes, they are a reasonable substitute for gilt funds. This means investors should dig up past factsheets and not go by star ratings or past returns. This is why one should not ask which category would provide more returns. More returns = Lower Credit Quality.

If readers are interested, I can dig deeper, but this is no guarantee about the future! Today AMCs may be wary of credit events, but once the dust settles, they will start competing with each other for returns and guess how one gets a higher return in a Banking and PSU fund?!

I am not trying to suggest it is easier to select a gilt fund (more on this coming up). However, we expect their NAV to be volatile, and the possibility of a credit event is low if not zero.

In summary, if an investor wants a debt mutual fund for a long-term goal and understands the risk of choosing liquid funds or money market funds for this purpose should be ready to face both credit risk and duration risk (NAV volatility). Since NAV volatility is a certainty, choosing gilt funds at the very least reduces the chances of credit risk.

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