How to select suitable debt mutual funds with low credit risk?

Last Updated on December 29, 2021 at 11:54 am

Every time debt mutual funds face credit risk – a sharp drop in NAV due to the credit rating downgrade of a bond – investors get spooked. Credit risk is part and parcel of fixed income and debt mutual fund investing and one cannot run away from it. However, after the SEBI categorization rules, I believe it has become so much simpler to choose the right debt fund for the right occasion.  In this post, we discuss how to select suitable debt mutual funds with low credit risk.

The main risk with debt mutual funds is our expectations. We assume the NAV will move up like a straight line every day. Even with no credit rating downgrades, this is not possible and as the fund manager buys new bonds the NAV will move up faster or slower due to change in interest rates (also known as reinvestment risk).

Those who are unfamiliar with debt mutual funds and associated risk can download the free E-book: A Beginner’s Guide To Investing in Debt Mutual Funds

Never make this debt mutual fund mistake following Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile

How to select suitable debt mutual funds with low credit risk

1: Safety first for me, I can manage a bit lower return

Stick to overnight mutual funds and liquid funds with (a) large AUM or (b) that will not invest in corporate bonds (like Quantum Liquid fund) – part of My Handpicked Mutual Funds September 2018 (PlumbLine)

The large AUM will ensure exposure to individual bonds will be low. So even if there is a bond downgrade or default, you will not take much of a hit. If safety first is your motto then you will have to stick to these funds for all kinds of goals.  The advantage here is that you can stay put in these funds  right down to just a few days before you need the money (there are interest rate risks though – if RBI increases the rate too much too soon, liquid funds will fall but will recover soon)

2: I can take on some credit risk and some interest rate risk, but not too much.

In my opinion, this is the right attitude for long-term debt mutual fund investing. There is no need to run away from credit risk. We must understand it and use it well.

Some misconceptions about credit risk

1: Funds that hold only AAA bonds do not have credit risk. Wrong: the rating can change anytime and if moves down, the NAV will fall as the market price of the bonds will drop.

2: Banking and PSU funds do not have credit risk: Wrong. Any company can be degraded. They need not default (assuming the government will bail them out for at least some time), a downgrade is enough for loss. Also, remember that PSU will soon be fully public companies and bailouts will become tougher. Same for banks.

3: gilt funds are safe because they do not carry credit risk. Wrong. Technically gilts cannot be rated and hence there is no credit risk associated. But that does not make them safe. Longer the duration of the gilt, higher the fluctuations due to interest rate movements. Remember gilts can fall for months together.

So, how investors who are not terrified of credit risk invest? However, not too much risk of any kind though.

For duration below 5 years, stick to

• overnight funds
• liquid funds
• ultra-short duration funds (aka ultra short-term funds).

Buy funds with large AUM so that individual exposure is small. Check the past factsheets randomly to check if they have ever taken too much exposure to individual bonds (check from July 2018 at least, as many funds changed due to the SEBI rules).

For duration above 5 years, stick to

• Money market funds (short-term bonds with a maturity of about a year)
• Floating rate funds (min 65%) but strictly short-term and high credit quality. These funds minimise interest rate fluctuations. Read more: How Floating Rate Debt Mutual Funds Reduce Interest Rate Risk

If you are okay with exploring other categories with a bit more credit risk try (for above 5 years only)

• Banking and PSU Funds (80% of bonds, beware of the 20%)
• Corporate Bond funds (80% in highest rated bonds, beware of rest)

Be sure to pull out money before the goal just like equity.

If you can handle any amount of credit risk then use credit risk funds for very long-term goals (10Y+).

Avoid the following categories as their credit rating profile is not fixed and can be anything (unless the scheme document says so clearly)

• Low Duration Funds (bonds maturing in about a year or so or less)
• Short Duration Funds (approx 1-3 year maturity)
• Medium Duration Funds ( ~ 3-4 year maturity)
• Medium to long duration funds (~ 4-7Y)
• Long duration funds (> 7Y maturity)
• Dynamic bond funds. Read more: Do not invest in dynamic bond funds!

I have approximated the bond maturity as equal to the Macaulay duration of the bonds. This is a crude approximation. You can read more about Macaulay duration here: Why you need to worry about “duration” if your mutual funds invest in bonds

Simple thumb rule If you need money after X years invest in a fund that has an average portfolio maturity much less than X. I will repeat, never make this debt mutual fund mistake following Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile

When and how to use gilt funds?

Gilt funds are only for those who can exploit the NAV ups and downs due to interest rate fluctuations. There are two ways to exploit this.

• Trade in gilts using interest rate movements
• Use for long-term goals rebalance. Both equity and gilt with then give you plenty of opportunities to book profit in one and invest in another.

There are now two gilt categories

• Gilt funds with 80% in gilts across maturities
• 10Y Gilts. This is like a benchmark for long-term debt in India and serves to fix the PPF, SSY rates. This will be the most volatile fund among all debt categories (aside from credit default falls)

I strongly believe that after the SEBI  Categorization and Rationalization of Mutual Fund Schemes (source document for above classification), choosing a debt fund has become easier for those who know clearly what they want. Don’t blame funds if you don’t!

I also strongly believe that one should get their hands dirty with some credit risk for the long term. Unlike equity funds where anyone can buy stocks with a demat account, a debt mutual fund, especially an open-ended debt mutual fund is a unique product and investors should learn how to make the most of its liquidity and tax benefits. Naturally, there will be risks, but that risk is also present in a bank deposit.