Debt Mutual Fund Investments: Minimizing Risk

Franklin Templeton AMC hailed for its 'strong research' in selecting corporate bonds has come in for a lot of criticism due the downgrade (Feb 15th 2016) and subsequent default (March 9th 2016) of Jindal Steel bonds. A discussion on how to minimize risk associated with debt mutual fund investments.

First, a look at the Jindal Story

Feb 16th 2016

Mar 10th 2016

Franklin announced yesterday that they have sold all JSL bond.

Franklin-Jindal -steel

Can such risks of investing in debt mutual funds be minimised?

Before discussing that, what now for investors in these Franklin funds?

  1. Franklin was lucky to sell these bonds to an unknown buyer. ET Wealth report
  2. The annual return will take a hit because of this. Recent investors would have suffered a loss. There is no need to panic and sell, but introspection as to why these funds were chosen in the first place, is required in a hurry. Especially If these developments came as a surprise to you. I think one should not buy a fund which invests in risky paper (esp.for longer durations) just because the AMC/fund manager is 'good'
  3. Personally, I think,(a) Franklin has been walking on the wire with risky bonds in several of its funds. (b) It is extremely lucky to have found a 'buyer'. (c) Questions will be asked at headquarters.  (d) It will lose business at least in the corporate debt segment because of this.

Here are some simple steps to minimizing debt mutual fund investment risk

  1. Recognise that there every investment carries  some kind of risk, be it a fixed deposit, gold, equity, bonds, mutual funds etc. All we can do is to minimize the risk involved.
  2. Never invest on borrowed conviction. That is, do not invest because someone said so (including me, especially me). This includes Asan Ideas for Wealth, mutual fund advisors, SEBI registered advisors, financial planners - the whole lot. It is your money! Ask questions. Do not invest in anything that you do not understand. If hope is not a strategy, so is trust!
  3. Understand the risks involved. When it comes to debt funds, do not touch one unless you understand what modified duration, credit risk and interest risk stand for. Here are some posts on the subject
  4. Example:  Take the case of Franklin Corporate Bond Opportunities Fund - as of last month this is the fund with the largest AUM aside from liquid funds and Ultra Short Term funds.   It has a modified duration of about 2 years with a yield of about 11%.  The fund has lost about 1% in the last month or so (less than  that time actually). So it would take, (1%/11%) x 365 ~ 33 days to recover from this loss.
  5. Example: There is a common misconception that credit risk and interest rate are mutually exclusive. Look at how the Franklin Corp. Bond fund reacted when the government increased short-term interest rates by about 2% overnight in July 2013 to stem the fall of the Ruppee. Franklin-Corporate-bond-fundThere are no GOI bonds in that folio and yet the NAV fell. My understanding is that it is due to the fluctuating gap between corporate bond rate spread (yield curve technically) and the GOI rate spread.
  6. I am not saying stay away from corporate bond funds. One should understand the suitability of a product. Franklin says,
    • "This fund is suitable for investors with a medium to long term time horizon (at least 30 months and above) who would like to invest in the steadily developing corporate bond market which is likely to offer attractive risk - reward opportunity"
      • This means the fund offers reward, but with risk. Sometimes it offers reward and sometimes risk!
      • If an AMC says min duration is X years or months, as thumb rule multiply it by about 3-5. Invest only if you can stay invested for 3X to 5X. If you want the money sooner stay away from that product. Read more: Are Debt Mutual Funds an Alternative to Fixed Deposits?
      • Even if you like corporate bonds, the entire folio cannot be filled with them!
    • "This fund is also suitable for investors who would like to potentially benefit from high accrual and the prospect of capital appreciation of the fixed income securities over the long term"
      • Accrual implies 'hold the bond to maturity' and receive interest payments and money back. If the bond is downgraded then the probability of default increases like it did in mid-February.
      • Then interest payments were delayed and the ratings went to 'Default'. Franklin had to hurried find a buyer and sold for a loss. Now the loss in NAV is permanent and will take a month or a bit more to recover (assuming there are no other downgrades). As pointed by someone in twitter, 'accrual does not mean safe'!
  7. My standard refrain has been,stick to liquid funds for short-term goals and ultra-short term funds for all other goals. If you want to choose funds with a modified duration of more than 1 year, use it only for long-term goals.
  8. Many people think that if the average maturity is 2Y then it can be used for a 2Y goal. That is dangerous. For a 2Y goal, choose a fund with a much lower average maturity. This will minimise long recovery times if the NAV falls. Long recovery time will reduce returns. It is not just about 'getting money back'! So NAV recovering to zero loss implies low returns and loss of time.
  9. However, ultra short-term funds also have corporate bonds. The same can happen there too! If you are uncomfortable, but want a bit more return than liquid funds, choose short-term gilt funds (one needs to tread with caution though.Will do a detailed post on this soon). No credit risk here!
  10. Choosing a fund with a majority of AAA is one way to minimise credit rating risk. However, what if those AAA bonds are degraded? They could, but if the maturity of the bond is quite short, the associated risks are a bit lower.
  11. Another way to look at it is, not all AAA are the same. So instead of AAA corporate bonds, one can choose so-called 'Banking and PSU bond funds'.Are PSUs and banks immune to credit risk? Hell no! Probability is a bit lower depending on the duration and quality of the paper held.
  12. This has been a much longer post that I imagined. Let me close by saying that, in general it is a good deal to look at the portfolio of the debt fund and its investing style history from MorningStar before investing.

Debt Mutual Fund Selection Guides

How to Select Debt Mutual Funds Suitable For Your Financial Goals?

Investing in debt mutual funds: slow and steady wins the race!

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5 thoughts on “Debt Mutual Fund Investments: Minimizing Risk

  1. baljit

    sir,
    start respecting, or I say, dis-respecting ppf, fds in psu banks etc....
    good old love for these is bad..... but so is new hatred for them....
    rest GOD knows...

    Reply
  2. sundararajan

    However, ultra short-term funds also have corporate bonds. The same can happen there too! If you are uncomfortable, but want a bit more return than liquid funds, choose short-term gilt funds (one needs to tread with caution though.Will do a detailed post on this soon). No credit risk here!
    Hi Mr Pattu,
    I checked this SBI Magnum Gilt Fund - Short Term Plan. Modified Duration (yrs)* 2.27 and Average Maturity (yrs)* 2.94.
    but 80% of investments are in SOV.
    But you mentioned that one would choose Modified Duration (yrs) and Average Maturity less than one year.
    I am not sure if I am following. What should be the guidelines for short term guilt funds.
    Thanks

    Reply
  3. Mayur Shah

    Sir,

    As Franklin Templeton AMC has got rid of toxic assets now, can new investors enter into any of the above funds of Franklin if it meets investors criteria to invest ?

    Thanks

    Reply
    1. freefincal

      1) Not yet. See today's 13th Mar post
      2) Such toxic asset can spring up any time. It is not about the AMC. Understand fund strategy before investing.

      Reply

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