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Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile

One advice about investing in debt mutual funds that never made any kind of sense to me is: "pick a debt mutual fund whose maturity profile matches your investment horizon". You will find this in many articles online and here is why I think it is plain wrong.

Say you wanted to invest in a fixed deposit or a recurring deposit. What investment duration would you choose? Obviously, you would want the FD or RD to mature just before you need the money. The same is true of individual bonds or even closed-ended debt funds like fixed maturity plans (more on FMPs later).

A debt mutual fund invests in bonds of different types and duration. Some trade the bonds before they mature and some hold them until maturity and some do both.

Higher the duration of the bond, the more volatile it is. The more susceptible it is to interest rate movements and credit downgrades or defaults.

Let us for simplicity consider an open-ended fund that holds bonds until maturity. Debt income funds and corporate bonds funds are examples of these.

The maturity profile of a debt fund is a list of all the bonds it holds and their maturity dates.  This is information is neither easy to access  (not all fund factsheets include this, but morningstar has this), nor easy to process (50- 100 bonds or so).

So instead of a list, the average portfolio maturity is listed. This is a weighted average of bond maturities. A bond with more exposure will influence the average more. However, this hardly illuminating.

Take the case of Franklin India Corporate Bond Fund. It typically has an average maturity of about 3-Y years. However, at any given point in time, it can have bonds maturing a few months from now, to a few years from now (more of these).

So if I buy this fund today, because my investment tenure is say 4 years, the portfolio will have a basket of bonds maturing at different points in time - some next week (because they were purchased a long time back), some next month, next year etc.

So as they mature, the fund manager will add fresh bonds of different tenure.

The key point to recognise is: at any point in time during the next four years, the average portfolio maturity is typically 3-4Y. So it always holds bonds of that ~ duration.

What has changed is my risk tolerance. When I started out, I could handle the volatility associated with 3-4Y Avg. maturity. However, as time progresses and my intended redemption date nears, I cannot and should not be exposed to bonds of that duration.

This is the simple reason why it is poor advice to match investment tenure with maturity profile of the bond.

Suppose I had chosen an ultra short-term fund with a maturity profile of 3-6 months for my goal of 4 years. At any point in time, the bonds in the fund will mature in a few months. The associated volatility is way lower. In this case, I can afford to hold the fund for 4 years - until I need money.

This crude depiction sums this up.

debt-fund-maturity-profile
The curved arrows represent average maturity cycles. When bonds with most exposure mature and the fund manager buys more. This is of course, a simplistic view. Bonds mature and new ones purchased all the time.

How about the reward? By choosing a fund with shorter maturity profile, will the reward be lower?

Well, the answer depends on your definition of reward. No great wealth is going to be built with debt funds (alone), certainly not much over four years. So I would consider peaceful sleep as my primary rewards. As for returns,

As for returns, it does not depend on duration alone. The quality of bonds held matter. A BB bond will offer higher returns than an AAA bond. Would you then choose a BB bond in the hope that the issuer will not default?

It is silly to assume one type of fund will always return more than the other. These are market linked products and can go either way.

If my goal is 20 years away, and I don't mind some volatility, Franklin Corporate Bond can be chosen. Is it a better choice than an ultra short term fund - I don't know.

To sum it up: Matching investment duration with maturity profile of a fund is simply flawed. It ignores risk and has a simplistic notion of reward.

What should investors new to debt funds do?

Stay away from any debt fund with an average maturity profile greater than one year.

Read more:

Debt Mutual Funds: Risk vs. Reward

How to choose debt mutual funds with no credit risk and low volatility

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2 thoughts on “Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile

  1. Kushal

    Sir, I think your argument of investing in a short term fund, or not paying heed to avg maturity of the fund is flawed

    The basic of investing is to invest in secutrities with a view of expected investment horizon.

    People with more than say 7 years horizon should prefer equities and those with less than one year, should prefer liquid/ultra shor term bond.

    The above recommendation comes from the principle that the instrument chosen should be such that it gives maximum reward, while reducing exposure to the volitility of the asset class within the extected investment horizon.

    The recommendation of a ultra short term fund even for a 4 year horizon suits well if the investor is extremely risk averse and the obejctive is capital protection with a 99.99% probabiltiy (no instrument can ever guarantee a 100% protection; JPmorgan and Amtek). However, if you select a fund with an avg maturity of say 3 years, the volatility of such a fund should take care of itself within a 4 year period giving better performance than say, an ultra short bond fund.

    Lets apply the principle in your post to equities. Equtiies are an instrument with infinite maturity. Does it mean if i have a goal to save for my retirment in 30 years, i should never invest in equtiies as the avg maturity at retirement will be infinite?

    One can always choose to start with a high maturity asset/fund and gradually reduce the maturity profile to a short term one.

    This is of course from a theoretical perspective. Would love to hear your thoughts

    Reply

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