Open Letter to AMCs: Why are you not pushing Risk-free Debt funds enough?

Published: November 1, 2018 at 10:48 am

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In this open-letter to mutual fund AMCs, I ask why they not pushing risk-free debt mutual funds when it is so easy to do so?! Yes, a mutual fund with essentially no interest rate or credit risk. In spite of disclaimers and clear wordings in the scheme documents, investors like to assume that the NAV of a debt mutual fund will only keep increasing like a straight line and returns will be higher than a fixed deposit. Cleary the sales guys are also responsible for propagating the myth to close the sale. What if, in spite of NAV ups and downs, the return of a debt fund is essentially the same as its expected yield with no risk of default? Such funds exist, but not in the optimum format.

I know many AMC officials read or at least visit freefincal from time to time. I do not know if they will see the following or take it seriously, but write I have what in mind, I must. I have always maintained two things about debt mutual funds: (1) they are unique products (unlike equity funds) and (2) one must not shy away from risks associated with open-ended debt mutual funds but let to use them to our benefit. Many of the problems that investors face stem from Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile. However, a risk-free debt fund should be prominently offered as a choice to the investor.

Open Letter to AMCs: Why are you not pushing Risk-free Debt funds enough?

Dear AMC, the series of bond rating downgrades and defaults have spooked investors and you are going to lose  (or not gains as much) what you so dearly love AUM! Your grand vision of removing money from banks FDs and shifting it to debt funds is failing. What I fail to understand is, why are you not offering prominently investors the choice to invest in risk-free debt mutual funds? Why are not not offering the convenience of minimal lock-in and periodic open-endedness in such products? I am talking about fixed maturity plans (FMPs)and interval mutual funds that invest only in government bonds (gilts).  Yes, yes there are FMP that invest in gilts, but they are locked for too long a time.

There is no SEBI regulation that stops you from doing this. The talk about SEBI shutting down closed-ended schemes is only equity funds (welcome move btw, you cannot get easy AUM!). FMP or Interval gilts are a wonderful way to attract AUM from investors who want the safety of gilts and reasonably fixed return. Why not explore it?  I don’t have to explain FMP/Interval gilts to you, but let me do so for the benefit of the investor.

How to create a risk-free debt fund

If you are new to debt funds then download this free E-book: A Beginner’s Guide To Investing in Debt Mutual Funds

Suppose you buy a bond with the intention of holding until maturity (say 5 years). During this five years the RBI increases and decreases rates, the bond issuers credit rating falls, almost to the point of default. When all this happens, the price of the bond will move up (when rates fall) and down (when rates rise or credit rating falls). However, since you never sold the bond and held to maturity, the price fluctuations are not relevant to you. All that matters is, whether the bond issuer paid the interest on time and gave back your money after five years.

In an open-ended mutual fund, a fund manager will continuously buy and sell bonds and investors will continuously buy and sell units. So the NAV of the open-ended mutual fund will depend on the current market price of the bonds. If the bonds fall, the NAV will fall and the investors will either suffer a notional or real loss (if they redeem).

In a closed-ended mutual fund, investors cannot sell the units back to the AMC before maturity. So even though the NAC is market-linked,  the fund manager will typically hold the bond until maturity. As long as there is no default, the investor will get a return close to the yield of the bonds in the portfolio (weighted by exposure)

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Can you see where I am going with this? Now think of a bond issuer that you are sure will pay your interest on time and will give back your money? Yes, the government. For a citizen, the rating of a bond issued by its government is absolute and pretty much unshakeable, except in extreme situations. This has happened in the past. For example, PPF and EPF rates zoomed to 12% when India was on the verge of bankruptcy in the 1990s. See The evolution of Public Provident Fund (PPF) Interest Rates. However, there were no defaults.

Now consider a fixed maturity plan that invests only in gilts. The FMP is for say 1Y and the gilts will also be of 1Y duration. There is no credit risk here. There is no interest rate risk here as the fund manager will hold the bonds to maturity. The price of the FMP will move up and down during that one year but that is not relevant to the investor as she cannot sell the units back to the AMC (redeem) before the one year is over. Of course, she can try to sell the FMP via a demat account in the secondary market, but there will hardly be any buyers for it (at least that is the situation now).

It would be even better if an interval fund is used instead of an FMP. An interval fund is an FMP that opens for sale periodically. That is, a quarterly interval fund (for eg.) will remain closed for 3 months and then open for buying and selling for about a week or 10 days and then close for another 3 years, open again and so. So the investor will get the benefit of an open-ended fund and a closed-ended fund with a minimal lock-in. The interval can be yearly, quarterly or monthly. The duration of the bonds that the interval fund will hold will match the period for which the fund will remain closed.

So consider a quarterly interval gilt fund. It will be 3-month gilts and hold it for 3 months. Then during the open period,d it will simply hold cash allowing for redemptions and fresh purchase and then buy 3-month gilts again and remain closed.

Is this truly a risk-free debt fund?

Everyday risk of interest rate fluctuations and credit rating changes are eliminated. There are however be extreme situation risks

  • War, invasion, economic collapse where the government is unable to honour its debt (let us hope we never face this for if we do, our debt mutual fund loss will be the last thing on our mind)
  • The AMC absconding with the money! (possible, but not probable)
  • Too much selling in the secondary market! (possible, but not probable)
  • Deviation from investment mandate by the fund manager to get more returns and therefore AUM (eg. trading the gilts in the middle of the lock-in period). FMPs or intervals funds have this freedom to trade! They are however unlikely to sell for a loss!
  • Anything else?

These are not everyday risks and I think should be safely ignored. Holding a gilt to maturity is safer than a bank FD and I think a gilt FMP  or interval fund comes the closest to the “perceived” safety of the FD.

Dear AMC, why are not creating such products? If I look at the FMP list at Value Research, I only locate 7 gilt FMP and 6 of them are medium term to long term. As regards interval funds (which are fine products even if they hold other bonds), there are only two interval funds launched after Feb 2013? Why? Don’t you know how to sell them? Engage me and I can train your staff and sales team. For a change, selling FMP/interval gilts will involve telling the truth about risk. You set the expense ratio as high as SEBI will allow and generate your dear beloved AUM.

Creating a risk-free debt fund which is liquid enough is trivial. All you need to do is to create interval gilts with monthly, quarterly or yearly periodicity. FMP gilts can be used for longer durations. Of course, there are idiots who will seek five star rated funds which take on credit risk and blame everyone else for their stupidity, but I can guarantee you that a majority of investors look for safety in debt funds.

If you agree, tag your fav AMC on twitter and bring this open letter to their attention.

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Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice.
He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com

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3 Comments

  1. Minor Typo in below line :-
    “Then during the open period,d it will simply hold cash allowing for redemptions and fresh purchase and then buy 3-month gilts again and remain closed.”

  2. zerodha allows one to invest in gilts directly, even 20, 40 year gilts with good interest rates. Wouldnt that be a nice alternative where there is no interest rate risk or credit risk

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