Last Updated on August 6, 2022 at 4:04 pm
This article lists the essentials an investor needs to keep in mind before selecting debt mutual funds.
(1) Debt mutual funds are not replacements for fixed deposits! Do not take product manufacturers (AMC guys) and sales guys seriously! A fixed deposit in a bank too big to fail has a risk so small that it can be reasonably approximated to zero. A debt mutual fund is a market-linked product. The NAV of a debt mutual fund reflects the current market price of the bonds in the portfolio.
This means we have no idea how the NAV will move and what the returns will be. Sometimes it can be higher than FDs, and sometimes not. If you cannot accept this hard reality, then debt mutual funds are not for you.
Debt mutual funds have tax advantages over fixed deposits when held for more than three years. However, care is required in the selection and understanding of risks.
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(2) The bond market is getting more and more popular. This means speculation has increased, and NAV movement will be determined by demand vs supply forces only. Theoretical ideas on how NAV will change will interest rate moves are just that – theoretical. We must appreciate and accept that such forces will result in sudden NAV up or downswing in any debt fund (incl liquid or overnight funds).
(3) A stock market crash will also affect the bond market (and vice-versa). Any sudden bad news will result in people selling bonds or not buying any more. This will adversely affect debt fund NAV.
(4) Never chase returns in debt funds. Never look at star rating or past performance to buy debt funds. The higher the return they offer, the more risk they have taken. This can risk can be classified into two broad categories.
- Credit risk: Ironic as it sounds, we expect higher interest from weaker businesses. So an A-rated bond will offer higher returns than an AAA-rated bond. The catch is that the A-rated bond issuer has a weak business, and their repaying capacity is lower and can further worsen.
- If a bond issuer defaults, the NAV of a debt fund will fall vertically and not recover until they repay. In the meantime, if the AMC sell the bond, the loss is permanent. Bonds issued by the govt cannot be classified in terms of repaying capacity for resident investors. They are simply called “sovereign” bonds. We just hope they will not fail; else, our problems will be much more than poor debt fund returns!
- Interest rate risk or duration risk: Higher the duration of a bond, the more volatile its price. This is because (for example) no one wants to be stuck with a long-term bond with rates increasing. All bonds have interest rate risk, whether issued by corporates or the govt.
(5) Simple thumb rules (technical): If your need is after X years, the average portfolio maturity of the (open-ended) debt fund portfolio should be much lower than X. Also, looking at the portfolio, one should check how much risk the fund is taking. Our monthly debt mutual fund screener helps in this regard: Debt mutual fund screener (July 2022) for selection, tracking, and learning.
(6) Simple thumb rules (non-technical) Stick to short-term funds with low credit risk like liquid funds or money market funds for goals less than five years away. Those uncomfortable with NAV volatility can use these funds for longer-term goals too.
Arbitrage funds typically have NAV volatility similar to debt funds. Those comfortable can consider these. They may not offer much in the way of returns but are a bit more tax efficient than debt funds as they are considered equity funds. See: How Arbitrage Mutual Funds Work: A simple introduction.
Funds like corporate bond funds or gilt funds can be considered for long-term goals with a proper asset allocation and regular rebalancing. Please note that these funds can take on credit risk (esp. corporate bond funds).
For fund recommendations, see: Handpicked List of Mutual Funds Jul-Sep 2022 (PlumbLine).
All other types of debt mutual funds can be avoided! For a list, see: List of Mutual fund categories that you can avoid!