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.
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).
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
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.
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.
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.