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

"What debt mutual should I choose as part of a long-term portfolio?", is a question that I am often asked.   EPF,  PPF and NPS (with no equity or only 15% equity as for government employees) are the first choices when it comes to debt or  fixed income products.  This is good enough for many salaried folks far from retirement.

For people who are not part of EPF/NPS and do not like the lock-in period of PPF, debt mutual funds are a good choice. Even the salaried folk are likely to require a debt fund as they edge closer to retirement if they wish to change the equity:debt allocation.

How about those who are retired? What kind of debt mutual fund should they choose?

Although, there are several categories of debt mutual funds, the choice is simple for those who have a  well defined goal and who understand the balance between risk and reward.

Fixed maturity plans can be used, but the lock-in (min 3 years these days) implies that it should be used with care.

People like me, who prefer open-ended mutual funds, can simply use ultra short-term funds or short-term income funds which buy and hold short-term corporate bonds until maturity (known as accrual-type funds).

The modified duration - a measure of how long the fund will take to recover  from interest rate movements - will be low for these funds.

So would the average maturity period of the portfolio. These are low-risk, relatively high/reasonably high reward options with full liquidity and min exit load.

There is also a misconception that dynamic bond funds can play the interest game well, resulting in higher returns. There is no evidence of that in this, and in previous studies (more on this later).

Much of what is mentioned above is based on the previously published posts:

Choosing Debt Mutual Funds For the Long Term

Debt Mutual Fund Returns: How to expect when you are expecting!

In this post, I would like to reiterate the above with an updated set of graphs  based on 12-year annual returns data from value research.

Average portfolio maturity vs. standard deviation

The average maturity period of the portfolio tells us what kind of fund it is. Liquid funds mature in about 90 days or less. Long-term gilt funds in about 15-20 years!!

In terms of increasing maturity period (apr:

liquid funds < ultra-short term < short-term;  income; short-term gilts < medium terrm and long-term gilts

debt-fund-standard-deviation-1

 

Notice that funds with low standard deviation (a measure of variation of the annual return from the average return) have low maturity periods.

Let us block funds with less than 3% standard deviation. This corresponds to a maturity period of 3Y or less.

The average maturity plotted above is the current number. We are assuming that it would not have deviated significantly in the past.

12-year CAGR vs. average portfolio maturity

debt-fund-standard-deviation-4

 

This graph never ceases to astonish me.  If I had chosen a fund with low average folio maturity, I would have witnessed low fluctuations in my annual returns (1st plot), but would have got a return comparable to other fund categories which are way more volatile. So why bother. Why invest in  'flavour of the season' long-term gilts funds? They are going to pare the gains made last year and perhaps this year when the interest rate cycle turns.

Why not keep it simple with ultra short-term or short-term funds?

The red box in this graph corresponds to 3Y or lower maturity - same as the first graph

Risk vs. reward

debt-fund-standard-deviation-3

 

The low-risk option would have got you as much as return as the high-risk option. It can be argued that the high-risk option is not suitable for buying and holding and only for tactical calls.  Which makes them more riskier and stressful!

Those who recognise the importance of a minimalist portfolio - minimal in form, minimal in maintenance, will recognise the merits of investing in funds with low average portfolio maturity.

Ultra short-term funds or short-term income funds which buy and hold short-term corporate bonds untile maturity (known as accrual-type funds) will get the job done slowly and steadily, will full liquidity.

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29 thoughts on “Investing in debt mutual funds: slow and steady wins the race!

  1. Syamantak

    This was the same argument that I posted on another thread, Pattu. To me, putting money in debt is to reduce the volatility (!) . Why to go for long term gilt funds then. Keep money in Ultra short term funds for 3 yrs and keep rolling. KISS
    Thanks for confirming this with mathematical proofs . 🙂

    Reply
  2. Syamantak

    This was the same argument that I posted on another thread, Pattu. To me, putting money in debt is to reduce the volatility (!) . Why to go for long term gilt funds then. Keep money in Ultra short term funds for 3 yrs and keep rolling. KISS
    Thanks for confirming this with mathematical proofs . 🙂

    Reply
  3. lakshminarasimman

    sir,
    should i chose dividend option or growth option which is better
    i am in 30% tax bracket

    Reply
  4. lakshminarasimman

    sir,
    should i chose dividend option or growth option which is better
    i am in 30% tax bracket

    Reply
  5. A.Sundaram

    After having experimented with all types of debt funds in various combinations in substantial quantities for nearly 15 years,could not agree more with you,dear Pattu.Ultra S.T.liquid funds for emergency requirements and S.T. accrual debt funds for others should serve well.With the increase in the LT taxation rules to 3 years for debt funds,playing the rate cycle thro' the dynamic bond route has become cumbersome and not worth the associated volatility.

    Reply
  6. A.Sundaram

    After having experimented with all types of debt funds in various combinations in substantial quantities for nearly 15 years,could not agree more with you,dear Pattu.Ultra S.T.liquid funds for emergency requirements and S.T. accrual debt funds for others should serve well.With the increase in the LT taxation rules to 3 years for debt funds,playing the rate cycle thro' the dynamic bond route has become cumbersome and not worth the associated volatility.

    Reply
  7. jaikumar

    I have rs 1 lakh which is reqd after a month. Should i keep it in liquid funds considering the fact that it is taxable

    Reply
  8. jaikumar

    I have rs 1 lakh which is reqd after a month. Should i keep it in liquid funds considering the fact that it is taxable

    Reply
  9. R Swaminathan

    The images in your posts are no longer visible in my system. If you click on them , you get an error message " THIS IS SOMEWHAT EMBARRASSING, ISN’T IT?
    It seems we can’t find what you’re looking for. Perhaps searching can help."
    Can you please let me know what needs to be done by way of setttings in my system to rectify this.
    Thanks

    Reply
  10. Kartick

    I'm not convinced that standard deviation is the right measure of risk.

    For example, it also includes upside risk, which isn't really risk. A fund whose returns fluctuate between 6 and 10% has a higher standard deviation than one that consistently returns 5%. In fact, it's the latter fund that's riskier. It has a 100% chance of underperforming the former fund.

    I think the worst-case performance of a fund is a better indicator of risk. This is for an investor who invested at the peak and redeemed at the trough. What percentage of of their capital did they lose? If they didn't lose anything, their risk is zero.

    Actually, I'm not worried about a single-digit loss, either. A single-digit percentage loss doesn't mean that I'm going to miss my financial goals. So, given that liquid funds, ultra-short term funds and short-term funds are all risk-free, why not pick the one that gives the highest return?

    It's equity that has a huge risk, with the market falling some 50 - 60% when the financial crisis struck. If I felt my portfolio had too much risk, I'd reduce the equity component.

    By way of analogy, I'm not worried that my car is unsafe because it doesn't have anti-skid braking. All cars are reasonably safe. It's the pedestrians and cyclists that are taking a risk.

    Is there anything I'm missing? Or a different way to look at this?

    Reply
    1. freefincal

      stdev is a not the right measure of risk because of its limited validity (values must form a normal distribution). Using only downside risk to calculate stdev is a bit of cheating imo. Think of a pendulum that sways left (-ve return) and right (-ve return). I could argue that the -ve returns came because of the +ve returns.
      I am all for using alternative means of measuring risk. I like Mutual Fund Analysis With the Ulcer Index
      which is based on downside risk, which is what you are referring to.

      Reply
      1. Kartick

        The Ulcer index is similar to what I had in mind.

        My main point, however, was that since most debt funds have negligible risk, I'd pick the category that has the most return, like short-term over ultra-short or liquid.

        I'd really want a debt fund that aims to provide the highest return for a long-term (20-year) investor without making me pick a specific duration like short-term or ultra-short-term. This would be the equivalent of a flexicap fund for equity, so that I don't have to pick between large-, mid- and small caps myself.

        Reply
  11. Mitesh Furia

    Pattu Sir, the 12 year CAGR in the graphs above show return just above 8.0% or thereabouts across maturities. The return percentage seemed a bit low to me as short term funds have returned close to 9% in some cases. Am i missing something?

    Reply
  12. Pratyush

    Actually if you check out the category average for various debt fund types on valueresearchonline or morningstar, LT score over ST score over UST.

    Kinda contradicts the above post.

    Reply
    1. freefincal

      Not really. The point of the post is that LT funds lose when rates go up what they gain when rates go down. Naturally, things will look rosy or bleak depending on when I look.

      Reply
  13. J.JAIKUMAR

    You should go for growth option since dividend in mutual funds are not like dividend in shares. The quantum of dividend reduces the Nav.

    Reply

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