How to choose debt mutual funds with no credit risk and low volatility

A method to choose debt mutual funds with no credit rating risk and low volatility  or interest rate risk from a category known as short-term gilt funds - is discussed. This is post is a follow up to  Debt Mutual Fund Investments: Minimizing Risk which referenced the fall in NAV of several Franklin Funds due to the downgrade and subsequent default and off-loading of JSPL bonds. Even before the dust settled on that, another bond held by many Franklin fund was downgraded by brickworthratings

Franklin-NAV-2 Franklin-NAV-1

Thanks again to Manoj Nagpal prompt and succinct tweets. Mint reports that Franklin has lost 512 Crore due to JSPL off-loading. From the report

“JSPL is going through some tough times because of external factors like Chinese slowdown and the failed auction of coal blocks. It did not default on any payments to Templeton. The sell-off, therefore, seems to be a panic reaction by Templeton,”

Note that FMPs are not free from credit risk too. A few ICICI FMPs have JSPL bonds.

If such falls in NAV (which will impact returns) are not acceptable to you, then what is the alternative?

I usually recommend liquid funds and ultra short-term funds. However ultra short-term funds are not free from credit risk.

Short-term gilts could well be an alternative. I learnt to take this category seriously thanks to one my earliest and oldest (~87) readers, Mr. Raghu Ramamurthy. He is the inspiration behind this post Comparison: Short-term gilt vs. long-term gilt vs. Ultra short-term mutual funds

Before we explore this category, let us establish some ground rules

  1. Zero credit rating risk. That is, no risk of default. The only way to do this is to invest in government bonds.
  2. Minimal interest rate risk.  Government bonds when purchased individually are free from both credit and interest rate risks. However, in debt mutual funds, all the bonds will be marked to market. That is, each day, the NAV will reflect their current value. This value will change with interest rate changes. When the interest rate fall, current bonds will become more valuable and the NAV will increase and viceversa when the rates fall.
    • Longer the duration of the bond, the more volatile the price movement.
    • Therefore to minimise interest fluctuations, the bond duration should be short. Hence short-term gilt funds. However, choosing one requires some care. Hence this post.
  3. The investment strategy of the chosen short-term gilt fund should be clear. In particular, the maximum duration of bonds allowed in the portfolio shoud be spelt out clearly in the scheme information document.
    • Lower the maximum duration allowed, lowe the averate maturity of bonds in the portfolio and lower the modified duration (measure of sensitivity to interest changes measured in years!)
    • When interest rates rise, the NAV of such fund will fall. However, the quantum of such a fall will typically be lower than long-term gilt funds and the time needed to recover will also be significanly shorter (days to weeks rather than months for long-term bonds). This too is measured by modified duration.

With these ground rules, let us head over to Value Research.

short-term-gilt-debt-funds

First, please allow me to sing my usual tune: why you should ignore mutual fund star ratings

This category has only 8 distinct funds, 16 if you count the direct plan options. Too small to justify the use of a bell curve to assign star ratings.

Now look at the average maturiy of bonds in the folio. They range from 0.24 years to 6.7 years. The biggest flaw in star ratings is to relatively grade dissimilar objects like here.

Incidentally, the direct plan option of many funds now have a higher star rating than regular plan options due to higher returns. This is a significant publically visible manifestation of outperformance.  If want help choosing mutual funds, Pay for Financial Advice, But Insist on Direct Mutual Fund Plans.

Only the fund marked in green will satify the low interest rate risk we desire. The ones marked in orange will have intermediate interest rate risk and the other high risk. In fact, in the medium and long -term category, one can find funds with less than 6 years average maturity.

If you like those three funds, the next step is to understand the investment strategy.

UTI G-sec Fund

Extract from the AMC site

  1. The UTI G-Sec Fund endeavors to offer stable and regular returns along with a decent capital appreciation over a period of time for those investors who invest with a long term horizon.
  2. The fund does not invest in state government securities and generally has a low portfolio churn.
  3. The UTI G-Sec STP aims at low volatility of returns by investing inshort term gilts.
  4. The maximum average maturity of the portfolio is caped at 3 years.

That is a clear, easy to understand mandate. However, if some bonds have an average maturity of 3 years, then the interest rate sensitivity will be a bit high. This fund is in general suitable for long-term  (well above 3) goals. Its current average maturity and modified duration are however quiet small.

ICICI Prudential Gilt Fund - Treasury Plan

"The scheme aims to generate income through investments in central and state government securities of various maturities. Provident Funds, Pension Funds, Superannuation Funds, Gratuity Funds and such other entities are eligible to make investments in the fund. The scheme seeks to generate steady and consistent return from a basket of government securities across various maturities through proactive fund management aimed at controlling Interest rate risk. The investment plan will invest in gilt including T-Bills with medium to long maturity, with average maturity of the portfolio normally not exceeding 8 years".

This is an extract from VR as the ICICI fund page and the SID is not as clear.

As far as ICICI MF is concerned, short-term is less than 8 years. This again is technically unsuitable for our needs, but perhaps can be used very long-term goals. However as above, its current average maturity and modified duration are however quiet small.

DSP BlackRock Treasury Bill Fund

This is the only fund left in the green rectangle.

"An Open ended Money Market Mutual Fund Scheme in Income Category seeking to generate income through investment in a portfolio comprising of Treasury Bills and other Central Government Securities with a residual maturity less than or equal to 1 year."

Says the DSP BR fund page. Now, this I like. Such a fund can be used for any duration from say, 2-3 years and above.

While any of the three funds mentioned satisfy our requirements of low-interest rate risk, the spread in such risk is still high. It is important to recognise this before choose one such fund.

Other funds in this category can also be considered for long-term goals but will react more to interest rate movements.

Fund sin this category do not have large AUMs perhaps because not many people are aware of this.

Note: No credit risk and low rate risk does not mean steay returns. The bonds yields will flutuate according to market demands, in addition to rate changes. Returns are likely to be sedate rather than spectacular.

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5 thoughts on “How to choose debt mutual funds with no credit risk and low volatility

  1. Abhishek Jain

    Should I invest money in ongoing Muthoot finance Ncd (closed on 3, May 2106)?

    I have some surplus money, Please suggest me.

    Reply

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