The Trouble With Debt Mutual Funds

Published: May 10, 2017 at 3:02 pm

Last Updated on

Debt mutual funds are not easy products to understand. The moment a bond can be traded in the middle of a tenure, the risk associated with it are often not obvious.  Regular readers would be aware that I have discussed this at length. To compound matters further, it is very hard to spot mutual fund that is style pure.

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That is, they do not have a well-defined investment strategy. Most funds (with the exception of pure gilt funds) can invest in several types of bonds with a wide range of maturities. This changes from time to time depending on interest rates. Unfortunately, this means the associated risk keeps changing.

An equity fund investor can rest at ease assuming that the risk is uniformly high. This is not the case for a debt fund investor. They will need to periodically keep an eye on the average portfolio maturity, modified duration and credit rating of the bonds in the portfolio. This is an annoyance.

For more information about these terms, you could download the  Free E-book: A Beginner’s Guide To Investing in Debt Mutual Funds.

In a recent post, Anirban Ghosh documented how he selected his first style mutual fund and chose IDFC Banking Debt Fund as a style pure ultra short term fund.

Unfortunately, less than two weeks later, IDFC Mutual Fund has announced a big change in the investing strategy of the fund. Here are some screenshots from the announcement

The current modified duration of the CRISIL Short Term Bond Fund Index is about 2Y.  So I think it is safe to assume that the IDFC fund is no longer an ultra short term fund.  Perhaps we can peg it as a short term income fund.

It is important to recognise that an  AAA rate bond of 1-month duration is not the same as an AAA bond of 1Y duration. Longer the duration of the bond, the more sensitive it will be to interest rate risks. Also, a credit rating downgrade could affect longer bonds more than shorter bonds.

Such changes in the “fundamental attribute” of a mutual fund entitle investors to exit without load, within a stipulated date. But that is cold comfort.

As we mourn the death of an easy to grasp investment strategy (see Anirban’s post above), it is important to recognise why debt funds have this tendency to prefer a broad investment universe in terms of bond category and duration.

The root cause of this problem is us – the investors who chase after returns, take star ratings seriously and do not worry about risks until it strikes. This makes fund houses take excessive risks to stay in contention.

Moral of the story: Keep an eye on your debt fund!

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  1. Hi Pattu,
    Great post as always. Wanted to know your opinion on certain aspect of balanced funds. In you look at Scheme info document, they have almost complete leeway on the debt portfolio. Duration for the debt portion is typically quite high.
    What do you make of it? And does that change anything?

    1. ha ha! Good point. Luckily the equity volatility is high there that the debt fund volatility is nicely masked. It is a problem but when everyone does the same thing what do we do?!

  2. If your time horizon is >20 years and have an asset allocation strategy which has a reasonable amount of equity (say 60% or more) and you also have access to EPF, PPF etc, for a significant portion of the debt allocation, then it probably makes no sense to obsess over which debt funds to choose for the remainder of your debt allocation. You can just stick to liquid funds. The long term portfolio growth is still going to come from the equity part and the debt funds can just act as a rebalancing tool.

    The longer I stay in this game (have had interest in personal finance since 2010) of investing, I realize that the simpler the portfolio, the better. My long term strategy is to just hold one or two balanced funds for ~ 60% of the portfolio and the rest in EPF, PPF and liquid funds. As long as I am saving more than 50% of my income during my earning years, things should work out well…

    1. I agree that there is no need for any kind of debt fund for any kind of need. However, I will not belittle the importance of fixed income in a portfolio. The assumption that over the long term equity will deliver is flawed. It may or it may not.

  3. At a broad level, if we choose short term debt funds ( I am using this terminology in a generic sense) with good credit quality and if we are prepared to stick to them for long durations, can’t we minimize the risks?

    There can be exceptions that can be weeded out through periodic monitoring…

    1. Even good credit quality is a vague term. A single credit downgrade is enough to cause liquidity issues. The risk does not depend on the duration of the investment.

  4. Pattu , Now that IDFC has become a Banking and Debt fund along the lines of HDFC , UTI and others ST bonds. ( Once you had suggested to invest in such fund (PSU Debt ) for safety reason over other ST Funds )

    Is it safe to invest in UST bond with Average Maturity of ~ 0.6 – 0.8 but and average credit quality of AA type ?

    Funds like UTI Treasury Advantage Fund – Institutional Plan , SBI Treasury Advantage Fund and others listed in Valueresearch have such profile.


    1. It is a question of risk premium. By seeking AA type of a folio, you expect the reward for taking on higher risks. It will work as long as there are no downgrades. Fundamentally credit risk is the same for a AAA folio and AA folio. The former is like tightrope walking from the first floor and the latter from the 3rd floor.

  5. What I meant is this. Let us assume that a credit downgrade results in the NAV falling by 1%. Let us also assume that a small hike in interest rates decreases the NAV by another 1%. An ultra short term fund may recover these combined losses in some time , say a few months or earlier.

    So, I was suggesting that if one is invested for a longer duration, one can recover from interest rate risks. What I meant by good credit quality is if a fund has invested at least 85% of its portfolio in AAA / A1/ Sovereign/ etc.These can also get downgraded. However, this may still be a workable approach to minimize credit risks.

  6. sir,
    i just read all your articles on debt MFs. so much of knowledge will trickel down my brain slowly (hopefully).
    first and foremost, i am consoled that i always found understanding debt funds was very very difficult and your comments are consoling.

    Few doubts have come to my mind during the process, if you can clear them, it will be nice.

    temporary loses of the fund get covered up with time, so is the temporary gains also reduce and mearge with normal growth of the fund with time ??
    2 if someone can buy debt fund on the day/days of temporary lose, will he be a big gainer.
    TDS deducted by banks can be claimed back or can be adjusted against other income by filing IT return, so in your calculator is this factored if one chooses to pay tax on maturity of FDs only (although a bad choice to follow that meathod as per you and i fully agree).
    is investing in debt fund because of reduction of interest rates only justified. because any funds nav must have been adjusted to any such change already. old investors must have been benefitted, but so is the case with those who have made FDs in old rates. new investors in both will be subject to new rates.
    regards and thanks in adwance

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