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

Since the time my step-by-step guide to selecting (Equity) mutual funds become popular, I have been receiving requests to publish a similar guide for debt mutual funds.

Well begun is half-done. If an investor can confidently select categories suitable for their financial goals, short-listing a set of funds from that category is that much easier. This is especially true for debt funds, since choosing one is typically tougher than equity funds.

Although I intended this post to be a companion piece to the more general, How to select mutual fund categories suitable for your financial goals,  as I wrote it, enough aspects have been included  to consider this as a step-by-step selection guide for debt funds.

Interest rates and bond prices have a fascinating relationship. Therefore, besides the usual risk-return parameters of alpha, beta, standard deviation, Sharpe ratio, Sortino ratio etc used for equity mutual funds, quantities like yield, yield to maturity, average portfolio duration, modified duration etc. are involved in debt fund selection/evaluation.

This makes the selection process appear complicated. However, this can be simplified by focussing on 1/2 parameters to first narrow down the debt fund category and then short-list funds from that category.

Thanks to the recent crash in bond prices, a visual analysis is possible.

On July 16th 2013, the 10-year G-sec rate increased by 6.69% while the 1-year G-sec rate increased by a whopping 14.8%. Source: www.investing.com

While the steps taken by RBI to curb rupee-depreciation was the main reason for this, other events played a part too. See here for a decent report.

The value of a bond has an inverse relationship with interest rate. If interest rates increase, the value of a bond has to fall  in order to match current yields. Therefore, the NAV of a bond fund holding such bonds will decrease.

Since both the 1Y and 10Y rate jumped up sharply, pretty much bonds of all durations were affected, resulting in a fall in NAV of almost all types of funds.

Even liquid and ultra –short term funds, with maturity durations much less than a year, were affected, because banks pulled out huge amounts of money stashed in such funds.

Since this event occurred less than a year ago, the default option (1Y) in the performance tab of each debt fund page at Value Research Online shows how funds behaved during this period.

This offers a simple way to understand how different types of debt funds react to interest rate movements, aka interest rate risk – one type of risk that debt funds are subject to.

First, let me quote two definitions:

Modified Duration : Measured in years, modified duration is a measurement of a bond’s sensitivity to movements in interest rates. For example, a bond with a modified duration of 5.2 years can be expected to undergo a 5.2% movement in price for each 1% movement in interest rates. The longer the modified duration (in years), the more sensitive a bond’s price to changes in interest rates. Source: Invesco Perpetual

Average Maturity: The average maturity of the portfolio determines the time involved in maturing of all the debt assets in the portfolio of the debt mutual fund. Higher the average maturity of the portfolio greater would be the interest rate risk on the portfolio of the debt mutual fund. Source: MoneyControl

Both the modified duration and  the average maturity represent the sensitivity of the debt fund portfolio to interest rate movements.

While average maturity is a crude measure of interest rate sensitivity, the modified duration is a more sensitive measure.

Just by noting the values of these two parameters, one can understand how interest rate risk affects different debt fund categories.

Here is a compilation of average maturity and modified duration for different fund classes. I have deliberately avoided defining each fund category in the post. Those who are familiar with them should not worry too much. If you are new to debt funds, then I suggest you come up with your own definition of fund categories by observing the maximum values of the average maturity and modified duration.

How to Select a Debt Mutual Funds
Source: Value Research Online. In some cases, the average maturity and modified duration are not for the same fund. The typical order of the values is however correct.

Performance in the past year 

Debt: Liquid.  Let us look at the fund with highest average maturity (AM) (0.2 years) and highest modified duration (MD) (0.18 years).

How to select debt funds. Liquid funds

 

Notice the little bump in the NSE Treasury Bill a little after the bond crash. The fund however was practically unharmed. If you peer a little you will notice a small dip on July 16th. Notice how fast the fund bounced back – in a few days.

Debt: Income Let us look at two funds.

The fund with lowest category AM = 0.44 years , MD  =0.37 years

How to select debt funds. Income

 

Notice how the fund suffered a dip on July 16th but recovered in a couple of months.

Now let us look at the fund with the highest category AM = 13.62 years; MD = 6.95 years.

High modified duration

The fund is yet to reach its July 16th NAV.

Similar plots can be made for the short term gilt funds. Imagine the fate of the Debt: long term funds!

Therefore, in general, higher the average maturity of the portfolio, higher the interest rate risk.

Higher the average maturity, higher the modified duration.

Higher the modified duration, higher the interest rate risk. The value of the modified duration gives you a more exact estimate of how much the NAV will be affect for 1% change in interest rates.

Typically funds with low AM and MD will follow an accrual strategy. That is they will buy and hold debt paper until maturity. So interest rate risk is lowered. However, credit risk comes into play. Lower the quality of the debt paper, higher the credit risk and higher the interest rate!

SEBI allows fund houses to buy credit protection (sort of an insurance) to hedge credit risk on corporate bonds. So that offers some comfort to the investors.

How do we use this information to select mutual funds?

When it comes to debt fund investors, I can think of three types

1)     Those who are always chasing interest rates, double indexation etc.

2)     Those who are looking to invest for short term goals, less than 5 years away

3)     Those who are looking to invest for long term goals, as part of diversified folio.

We will leave type (1) alone. Obviously they know what they are doing.  We will leave the high AM, high MD funds to these guys.

Where kind of funds should type (2) investors choose?

They should choose a fund with average maturity well below the tenure of the financial goal.

For a 5 year goal, I would choose a modified duration and average maturity of no more than 1 year.

Which kind of fund to invest in? Now we will need to look into the nature of the debt holdings. Is it corporate debt? It is Bank paper? It is govt debt (gilt)? What is the rating of the debt paper?

For important goals, best to stick to high quality debt issued by banks and PSU

Short term gilt funds with lower MD can also be used, but the returns would be on the lower side.

For less-important goals, you can be a little more adventurous and include some corporate debt. Here again stick to funds that have predominantly ‘AAA’ securities in their folio.

So investors should first look at low interest rate. The risk (AM & MD) , shortlist couple of fund categories and then choose funds with low credit risk (quality of debt).

Here is a screenshot from the ValueResearch portfolio page showing the AM, MD and the fund style box. We should funds with high credit quality and low interest rate sensitivity for short term goals. Most investors with a goal in mind, should stay within the red circle.
modified duration and average maturity

Once the fund category is chosen, you can short list funds using the risk-return parameters (alpha, beta, standard deviation, R-squared, Sharpe ratio) using the same strategy as outlined in the step-by-step mutual fund selection guide. If you would like to understand risk-return parameters in a simple non-mathematical way, click here

This would enable you to short-list low-risk, reasonable-return funds from the category of your choice.

The next step would be to look at the fund objective and investment strategy. Some fund houses like Franklin Templeton mention this clearly on each fund page. If the information is not clear, read the scheme document. Do not ask anyone else!

The objective and investment strategy must give you the impression that the current AM and MD will more or less be the same for the investment tenure you have in mind.

If yes, go ahead and invest!

NEVER invest in a debt fund without reading the investment objective and investment strategy.

Where kind of funds should type (3) investors choose?

First let us understand what we need debt funds for long term goals which would typically have significant equity.

  • Why not PPF? PPF is not suitable for goals less than 15 financial years away
  • PPF is good but it does not allow rebalancing. You can book profits into PPF but not vice versa when you want to.
  • With a debt fund there is a chance for high returns which could be  transferred to equity when the markets fall. So debt funds allow for rebalancing which if done cleverly can contain portfolio volatility significantly.

Just like a diversified equity fund, a well diversified debt fund like a dynamic bond fund with modified duration and average maturity of no more than 2-3 years will do the work. The NAV will fluctuate and that is fine, since we need fluctuations for rebalancing! You can learn more about rebalancing here. Be sure to play with the simulator tool.

Just as the concept of standard deviation can help a newbie mf investor understand different fund categories, the concepts of average maturity, and modified duration can help the newbie debt fund investor to pick a category suitable for their needs.

Debt funds selection can typically be more complicated than equity fund selection. It is up to the investor to simplify this process by being clear on what they want. They should learn not to chase after returns and keep expectations low.

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57 thoughts on “How to Select Debt Mutual Funds Suitable For Your Financial Goals?

  1. B

    I have seen that in long term liquid funds give almost equal returns to all other types as interest rates tend to average out…can any body confirm this??? Pattu ji I have seen from standard websites that liquid funds or ultra short term funds, infact provide moderately better returns than other riskier debt funds over as long term!!! than why take
    any risk???

    Reply
    1. pattu

      Precisely. Well said. Fully agree. However one should plan accordinly and take only 6%/7% from the liquid fund.

      Reply
  2. B

    I have seen that in long term liquid funds give almost equal returns to all other types as interest rates tend to average out…can any body confirm this??? Pattu ji I have seen from standard websites that liquid funds or ultra short term funds, infact provide moderately better returns than other riskier debt funds over as long term!!! than why take
    any risk???

    Reply
    1. pattu

      Precisely. Well said. Fully agree. However one should plan accordinly and take only 6%/7% from the liquid fund.

      Reply
  3. B

    can u suggest some investment options,..PPF FULLY TOPPED, term insurance taken,, SUFFicient investmetns in MF's through SIP;s,.. not interested in real estate as am expected to get substantial from my father,...currently parking surplus in liquid funds..and the kitty is growing monthly...

    how do you rate NPS??

    Reply
    1. pattu

      Stay away from NPS. if you have enough emergency fund, take the surplus you have parked in liquid funds and invest in your mfs when the market tanks by a huge amount and pull this back to liquid when there is big rally. Repeat!

      Reply
  4. B

    can u suggest some investment options,..PPF FULLY TOPPED, term insurance taken,, SUFFicient investmetns in MF's through SIP;s,.. not interested in real estate as am expected to get substantial from my father,...currently parking surplus in liquid funds..and the kitty is growing monthly...

    how do you rate NPS??

    Reply
    1. pattu

      Stay away from NPS. if you have enough emergency fund, take the surplus you have parked in liquid funds and invest in your mfs when the market tanks by a huge amount and pull this back to liquid when there is big rally. Repeat!

      Reply
  5. Aparna

    Where do you get AM and MD for each fund. It doesn't appear in VR fundcard. Searched in web, couldn't find it.

    Reply
  6. Aparna

    Where do you get AM and MD for each fund. It doesn't appear in VR fundcard. Searched in web, couldn't find it.

    Reply
  7. km

    Dynamic bond funds rely on the competence of the fund manager in terms of TIMING vis-a-vis his selection of the right duration of paper at the right time based on his interest rate view. I wouldn't be too comfortable trusting a fund manager's TIMING with my long term goals.

    For all types of goals, I would go with shorter term funds (short, ultra short, liquid) where interest rate sensitivity is lower. For more 'exciting' returns I would go for equity.

    The other aspect to look for is expense ratio. In a debt fund high expense ratios can eat away a lot of returns.

    Reply
    1. pattu

      I agree with you. A well diversified dynamic bond fund can provide buying and selling opportunities which can be used for two-way rebalancing with equity. As long the dynamic fund is reasonably diversified and does not churn its folio too much in response to interest rate swings, it is not a bad bet for long term goals.

      Reply
      1. VINAY MAITHANI

        How does Hybrid Debt conservative and aggressive feature in as compared to normal debt funds highlighted above ?

        Are debt funds good parking bay for someone very close to retirement ...who is in 30% tax slab and has exhausted 1 Lakh 80c and sufficient home loan interest exemption for first and second home ?

        Reply
        1. pattu

          Such fund should give your better returns. A good such fund can be used for intermediate term goals (5-7) years or so. Close to retirement, you will have evaluate your corpus and then decide. I am doing a post on this soon.

          Reply
  8. km

    Dynamic bond funds rely on the competence of the fund manager in terms of TIMING vis-a-vis his selection of the right duration of paper at the right time based on his interest rate view. I wouldn't be too comfortable trusting a fund manager's TIMING with my long term goals.

    For all types of goals, I would go with shorter term funds (short, ultra short, liquid) where interest rate sensitivity is lower. For more 'exciting' returns I would go for equity.

    The other aspect to look for is expense ratio. In a debt fund high expense ratios can eat away a lot of returns.

    Reply
    1. pattu

      I agree with you. A well diversified dynamic bond fund can provide buying and selling opportunities which can be used for two-way rebalancing with equity. As long the dynamic fund is reasonably diversified and does not churn its folio too much in response to interest rate swings, it is not a bad bet for long term goals.

      Reply
      1. VINAY MAITHANI

        How does Hybrid Debt conservative and aggressive feature in as compared to normal debt funds highlighted above ?

        Are debt funds good parking bay for someone very close to retirement ...who is in 30% tax slab and has exhausted 1 Lakh 80c and sufficient home loan interest exemption for first and second home ?

        Reply
        1. pattu

          Such fund should give your better returns. A good such fund can be used for intermediate term goals (5-7) years or so. Close to retirement, you will have evaluate your corpus and then decide. I am doing a post on this soon.

          Reply
  9. B

    The experts are split down the middle about NPS..the naay guys say taxability, compulsay annuity & limited equity are its down side..what is your reason about staying away from NPS??
    I think taxability of withdrawn amount is as per debt funds and not as per slabs..right?
    Thanks sir..

    Reply
    1. pattu

      Taxability is not yet clear. Should be as debt funds. NPS is a complex product. For me it is mandatory. If it is not mandatory keep it simple.

      Reply
  10. B

    The experts are split down the middle about NPS..the naay guys say taxability, compulsay annuity & limited equity are its down side..what is your reason about staying away from NPS??
    I think taxability of withdrawn amount is as per debt funds and not as per slabs..right?
    Thanks sir..

    Reply
    1. pattu

      Taxability is not yet clear. Should be as debt funds. NPS is a complex product. For me it is mandatory. If it is not mandatory keep it simple.

      Reply
  11. Raghu Ramamurthy

    I need a clarification from you regarding investment in Sundaram Gilt Fund. It is a short term gilt fund investing in 91 Days RBI treasury bills.These Bills have a normal coupon rate of about 8.5% to 9%.
    This fund has given an amazing 1 year return of 17.82% as on 17.4.2014.
    My doubt is how can give such a high return to investors by investing in 91 days Traesury Bills?
    I have posed this question to many so called experts.So far no one has clarified this issue.I hope at least you can educate me.

    Reply
  12. Raghu Ramamurthy

    I need a clarification from you regarding investment in Sundaram Gilt Fund. It is a short term gilt fund investing in 91 Days RBI treasury bills.These Bills have a normal coupon rate of about 8.5% to 9%.
    This fund has given an amazing 1 year return of 17.82% as on 17.4.2014.
    My doubt is how can give such a high return to investors by investing in 91 days Traesury Bills?
    I have posed this question to many so called experts.So far no one has clarified this issue.I hope at least you can educate me.

    Reply
  13. IamNoSpecial

    Most comprehensive post on debt mutual funds written till now by anyone.
    As you clearly pointed out, selection of debt mutual funds is more complex than equity funds and hence we find fewer articles on selection of debt mutual funds (and almost none like yours)
    I think, B rightly pointed out that we can have a combination of equity (or even balanced funds) and liquid funds and can have a good night sleep (wrt MF), right?

    By the way, what does 'income' in income funds exactly mean? Is it the dictionary meaning or is just eye catcher?

    Thanks,
    Viren Phansalkar

    Reply
    1. pattu

      Many thanks Viren. I don't know the origin of the word 'income' in these products. I dont think it related to their holdings in any way.

      Reply
  14. IamNoSpecial

    Most comprehensive post on debt mutual funds written till now by anyone.
    As you clearly pointed out, selection of debt mutual funds is more complex than equity funds and hence we find fewer articles on selection of debt mutual funds (and almost none like yours)
    I think, B rightly pointed out that we can have a combination of equity (or even balanced funds) and liquid funds and can have a good night sleep (wrt MF), right?

    By the way, what does 'income' in income funds exactly mean? Is it the dictionary meaning or is just eye catcher?

    Thanks,
    Viren Phansalkar

    Reply
    1. pattu

      Many thanks Viren. I don't know the origin of the word 'income' in these products. I dont think it related to their holdings in any way.

      Reply
  15. Pattabiraman Murari

    My understanding is that being an ultra short term guilt fund, it immensely benefited in May-July 2013 when 1Y and 10Y interest rates rose sharply. At that point its AUM was smaller than the present 32 Cr. So it was able to quickly lock the gains by selling its gilt holdings and moved onto cash and been there ever since. This is the only way I can explain the huge gains.

    Reply
  16. Pattabiraman Murari

    My understanding is that being an ultra short term guilt fund, it immensely benefited in May-July 2013 when 1Y and 10Y interest rates rose sharply. At that point its AUM was smaller than the present 32 Cr. So it was able to quickly lock the gains by selling its gilt holdings and moved onto cash and been there ever since. This is the only way I can explain the huge gains.

    Reply
  17. Venkatesh

    When 10 Year GOI yields are hovering around 8.7%, it is worthwhile for investors with a risk appetite to lock their funds in long term gilt funds. Of course, there is a risk if interest rates go up. But with an investment time frame of >3 years, investors should be able to beat the returns from other debt funds.

    Reply
    1. pattu

      Well that is one way to go. I wont be so sure that a time frame of just about 3Y is enough. It all depends on circumstances. I have a lot of such bonds in my mandatory NPS account and it one year for the fund to recover from the July 2013 crash.

      Reply
  18. Venkatesh

    When 10 Year GOI yields are hovering around 8.7%, it is worthwhile for investors with a risk appetite to lock their funds in long term gilt funds. Of course, there is a risk if interest rates go up. But with an investment time frame of >3 years, investors should be able to beat the returns from other debt funds.

    Reply
  19. VinMan Consulting

    If the goals are >10 years away risk calibrated equity exposure is already present. Then what should be the ideal debt portfolio mix consisting of Liquid / Ultra Short Term / Short Term / Income / Gilt Short term / Gilt Med & Long term ?
    I am so confused, in one way performance of liquid & UST are better than Gilt long term, but risk of interest rates getting increased in future is a point which goes against them.
    Do we have such thing as 'diversification of debt funds' in the debt component of one's portfolio ?

    Reply
    1. pattu

      For such long term goals, you can go with long-term gilt funds. They will give you entry and exit points with rate increase or decrease which can be rebalanced with equity.

      Reply
  20. Sundararajan

    Thank you on selecting Debt mutual funds. I have a question and I understand that you don't give personal or specific advice on this blog.. But after reading so many blogs / articles I am bit confused. This is my situation.

    I have to generate income Rs 5 lakhs per year for next 10 to 15 years. This should be (relatively) risk free since this is required for month to month expenses.

    Bank FDs may be an option - Even at 20% tax rate, after tax return will be in the range of 7% which is bit less. But it is the safest option. I already have some FDs with interest income.
    Tax free bonds - Invested some last year, but no new this year. May buy in secondary markets, but not sure how much premium has to pay This is also very safe option.
    Dividend from mutual funds - I believe that one has to pay tax at 20% rate. More over, it is risky to depend on regular income. One has to accept some years one can get more income and some years less or nothing.
    Debt / liquid / gilt etc funds - I haven't invested anything so far, but this could be an option. Don't know the difference between each one also.
    FMP -I believe this is another less risk option and tax can be avoided using double indexation.

    Can you throw some light on which would be the best /better way to go? I have to consider the capital required and best after tax regular return with less risk.

    Please let me know. Thanks,

    Reply
  21. Ashish Gupta

    Hello,

    Wandered to this website searching for some calculator, and then read through all the archives since last night. Your approach, analysis and explanations are slightly different from other Indian personal finances website I follow, so it was good learning.

    A request though: Can you not be condescending and sarcastic when talking about investors which are likely stupid in your opinion? You aren't for 99% part, but for 1% here and there (investor option 1 in this post), it tend to show. You can simply say "don't do it" if you don't recommend that approach.

    Anyway, thanks and now and I am regular reader. Also requested membership to FB group AIFW too.

    Reply
    1. pattu

      I think you are referring to: "Those who are always chasing interest rates, double indexation etc."
      I am certainly sarcastic, yes. Condescending is your interpretation. Different people interpret my writing and tone in different ways. There is a distribution in that too. There is not much I can do about it.

      Reply
  22. Nithin

    Is there any way to forecast interest rates by observing any macro variables ? (Both direct or indirect). I heard it varies in cycles. For instance we are now in an interest rate falling cycle and from my understanding another rate cut of 50 basis points is speculated by FY16.

    How do we know the end of these rate cuts ? I am asking this because based on this one would need to move debt fund money back to the bank...

    Also historically, how long has any interest rate fall/rise trend lasted ?

    Reply
  23. Syamantak

    Pattu,
    Why should some one look into the long term debt funds at all? for example, if I plan for a goal 10 years from now, can I not keep rolling using ultra short term funds or FMPs? Certainly their modified duration is not worrisome so there is a good chance of capital protection if the credit risk is not a concern. what benefit an investor could gain from investing a long term debt fund over consecutive periods of ultra short term funds?

    Reply
    1. freefincal

      Precisely. Long-term gilts funds are for those who wish to trade - buy and sell at opportune times. What you suggest is perfect. You can even consider having some exposure to corporate bond funds with a bit higher modified duration. They will be more volatile, but the bonds will be held to maturity.

      Reply
  24. Sunil bhagat

    what about credit opportunities or the accrual funds like Franklin STIP or Birla sunlife Medium Term plan, or the Birla Short term opportunities fund. Can we expect them to give an XIRR of 8% or above in a 3 yrs period

    Reply
  25. Vinod Sharma

    How would investing in any Gilt, Debt or Liquid Fund benefit for duration shorter than 3 years? Any gains get taxed at slab rate. Wouldn't it make more sense to look at Funds with at least 3 years period so that benefit of indexation as well Long Term gains can be used. I don't understand the need to switch between Debt and Equity or between Debt to Debt if the period is less than 3 years?

    Reply
  26. Rajni

    What type of debt funds should one invest in.
    Is debt funds only for emergency purpose or if I want fund that are liquid and perform better than PO or FD which can be best

    Do I do lumpsum or SIP in here as well.

    what about AXIS liquid plan or escorts fund house

    Reply
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