Choosing Debt Mutual Funds For the Long Term

If my financial goal is 15-plus years away, PPF is an obvious and pretty good choice for a debt instrument while trying to put together a diversified portfolio.  'Which debt mutual fund should I choose for the same purpose, if my goal is less than 15 years away?', is a question that is asked often enough.

The answer had presented itself to us earlier in an earlier post: Debt Mutual Fund Returns: How to expect when you are expecting!

debt-return-5

I was quite astonished to see debt funds with high average maturity (typically medium and long-term gilt funds) had a 10 year CAGR comparable to liquid funds!

So why bother taking on volatility that does not pay? Why not be content with simple accrual type ultra-short term funds? As reader Deep pointed out in response to this graph, "no brainer to go for liquid funds as both credit risk and volatility risk are lowest".

Let us now look at returns of all debt mutual funds categorized as per Value Research Online. The horizontal axis represents the number of mutual funds in each category and is not shown. Data is take from Value Research.

Last 10 year CAGR

liquid-10Y

Notice that liquid fund returns of all mutual funds are typically the same. So it does not matter which AMC you choose. What a relief! of course, this is just one data point. If we stare at  rolling returns, there will be some variation (see below).

Clearly funds with low average maturity  (liquid, ultra short-term and short-term) are less volatile across AMCs. Many comfortably best the  Debt-Income (including dynamic bond funds), Gilt-Short-term and Gilt-Medium and Long-term categories.

7 year average CAGR

Here is the average of the rolling 7 year CAGR.

liquid-7Y

Note:  It is unfair to include funds that hold bonds with maturity period greater than the duration over which we calculate returns. Therefore, when the duration is decreased the long-term funds lose relevance. However, I have included them in the graphs for an overall perspective.

Amusingly, this graph (and the ones to come) look similar to the 10Y return graph! The conclusions do not change!

5 year average CAGR

Average of the rolling 5 year CAGR.

liquid-5Y

Again, you can buy a liquid fund, liquid-plus fund or ultra short-term fund and relax!

3 year average CAGR

Average of the rolling 3 year CAGR.

liquid-3Y

Bottom Line

The next time an 'expert' says,  'match the average maturity of a debt fund with the duration of your financial goal', Let us ignore them!

Let us now look at rolling returns of two funds: a long-term gilt fund and a liquid fund.

Long-term Gilt fund

Gilt-fund-rolling-3

Notice the progressive decrease in returns.  The 15 year returns are steady but not spectacular. Considering the volatility and associated emotional stress, I don't think they are good enough.

Perhaps since the economy is supposedly reviving as we speak, interest rates will fall and the gilts will shine again!

However, 10+ years is more than one market cycle. So  what one gains when rate fall, one could lose when they rise again!  I am no expert, but I am willing to wager that this is the reason long-term gilt funds, if held for a long time, fail to impress.

 Liquid Fund

Liquid funds are not angels either! Their returns can vary quite a bit.

Liquid-fund-rolling

Please do not believe any 'expert' who says that liquid funds are better than fixed or recurring deposits. There is no guarantee that post-tax liquid fund returns would beat post-tax FD returns, irrespective of the duration. For 'short time periods, liquid funds are suitable when the redemption date and amount are uncertain.

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21 thoughts on “Choosing Debt Mutual Funds For the Long Term

  1. Pattabiraman Murari

    Sir, I am less than half your age. So please do excuse me if it reflects in my writing. I am a big zero when it comes to opportunistic plays. Since a rate is imminent, a long-term gilt fund makes perfect sense for you.

    Reply
  2. Pattabiraman Murari

    Sir, I am less than half your age. So please do excuse me if it reflects in my writing. I am a big zero when it comes to opportunistic plays. Since a rate is imminent, a long-term gilt fund makes perfect sense for you.

    Reply
  3. Arun Ramakrishnan

    BSL Medium Term fund holds assets which are AA and even A rated. So there is some amount of credit risk when compared to funds holding AAA bonds. It is also a corporate bond type fund when compared to other dynamic bonds which hold Govt Securities. This is something the investor has to keep in mind while investing. I think this article is spot on in its conclusion that short term funds are able to soundly beat the so called dynamic bond and long term funds. I learnt it the hard way by investing in BSL GSec fund and watch 2 years of return wiped out by the RBI repo hike in a single day 🙂 Hopefully others learn a lesson and just avoid betting on longer maturity paper.

    Reply
  4. Arun Ramakrishnan

    BSL Medium Term fund holds assets which are AA and even A rated. So there is some amount of credit risk when compared to funds holding AAA bonds. It is also a corporate bond type fund when compared to other dynamic bonds which hold Govt Securities. This is something the investor has to keep in mind while investing. I think this article is spot on in its conclusion that short term funds are able to soundly beat the so called dynamic bond and long term funds. I learnt it the hard way by investing in BSL GSec fund and watch 2 years of return wiped out by the RBI repo hike in a single day 🙂 Hopefully others learn a lesson and just avoid betting on longer maturity paper.

    Reply
  5. Raj

    Sir,

    For NRI FDs for 390 days I am getting 9.1 qtly, In this case it is better than PPF, Liquid and other debt funds. Only problem is liquidty. Earlier in March It was 9.25 then it comes around 10 % at maturity.

    Reply
  6. Raj

    Sir,

    For NRI FDs for 390 days I am getting 9.1 qtly, In this case it is better than PPF, Liquid and other debt funds. Only problem is liquidty. Earlier in March It was 9.25 then it comes around 10 % at maturity.

    Reply
  7. Uma Shashikant

    Do check the assumption that the rates on fixed deposit would have remained constant in the periods being analysed. Interest rates are inherently cyclical and long term returns for periods considered by you will show risk, irrespective of the product category. The PPF with its administered rates might be an exception, but over a 15 year period, those rates have also been modified.

    Reply
  8. Uma Shashikant

    Do check the assumption that the rates on fixed deposit would have remained constant in the periods being analysed. Interest rates are inherently cyclical and long term returns for periods considered by you will show risk, irrespective of the product category. The PPF with its administered rates might be an exception, but over a 15 year period, those rates have also been modified.

    Reply
  9. Pattabiraman Murari

    Thanks. I have made no such assumption on FDs. I only point out that there is no guarantee debt funds can beat FD returns. In this case as you pointed, all we can say is that liquid funds are likely to beat SB returns.

    Reply
  10. Pattabiraman Murari

    Thanks. I have made no such assumption on FDs. I only point out that there is no guarantee debt funds can beat FD returns. In this case as you pointed, all we can say is that liquid funds are likely to beat SB returns.

    Reply
  11. Thiru

    Thanks for this analysis. Came to this conslusion a while ago, but now its supported by your facts. However with the latest tax changes on debt funds I am moving towards arbitrage funds. My experience has been that arbitrage funds closely match liquid funds, though this has to be validated by your analysis.

    Reply
    1. pattu

      Thank you. Be careful with arbitrage funds. You are right that they are like liquid funds in terms of returns but there can be losses over a quarter. The risk involved is higher.

      Reply
  12. Thiru

    Thanks for this analysis. Came to this conslusion a while ago, but now its supported by your facts. However with the latest tax changes on debt funds I am moving towards arbitrage funds. My experience has been that arbitrage funds closely match liquid funds, though this has to be validated by your analysis.

    Reply
    1. pattu

      Thank you. Be careful with arbitrage funds. You are right that they are like liquid funds in terms of returns but there can be losses over a quarter. The risk involved is higher.

      Reply
  13. Harshit Patel

    Hi,

    Excellent Article, So should i conclude that even if you goal is around 5 or 10 years,investing in liquid funds is better than Long term debt or long term gilt funds?

    Reply

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