Investors who wish to give debt mutual funds a try often find that they are more difficult to understand than equity mutual funds 🙂 Who would have thought a fixed income product (a bond that offers regular payments like a fixed deposits) would be so hard to understand the moment it can be traded to another party in the middle of its tenure! But that is how it is. In this post, I discuss the types of debt mutual funds available and why it is so hard to choose a category, let alone a debt fund from a category!
Before we look at the features of the sheet, two quick announcements:
- V Ramesh, CEO of MF Utility will be joining Ashal and me at the Pune Investor Meet on Feb 26th. You can register via here. Only a few seats left.
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When it comes to equity funds, the classification is not perfect, but it works to a good degree for large-cap, mid-cap, multi-cap and small-cap funds. You can expect a large-cap fund to hold about 70-80% large cap stocks at any given months. Whether this is right or wrong is another matter, but at least it is easy to understand.
For equity funds, the reward is in terms of the capital gains. That is the value of the underlying stocks grown over time. The market capitalization of the stock is a reasonable measure of volatility. Large cap stocks are typically less volatile than mid-cap stocks, which in turn are less volatile than small-cap stocks.
The problem with a debt mutual fund is the presence of two parameters for both reward and risk.
Two factors determine reward:
A debt mutual fund NAV can increase because of the fixed income received from bonds and/or the capital gains(losses) due to change interest rates or change in credit rating of a bond.
Two factors also determine risk:
Higher the average maturity of the bonds in the portfolio, higher the volatility. The average maturity is the weighted average of bond tenures. If a fund holds more of long-term bonds that will increase the average maturity proportionally.
For a given average maturity (even low) lower the credit quality of the bonds, higher the potential volatility (may not be actual volatility).
For a more detailed introduction to these parameters, please consult: What is a Debt Mutual Fund? and links therein.
Only in the case of Liquid funds, thanks to a SEBI mandate, we have a clear demarcation in terms of bond maturity. These funds can only invest in bonds that mature on or before 91 days. This narrows down the field considerably.
However, they can invest in any kind of bonds - high quality to junk. So one needs to worry about that before selecting one: How to Choose a Liquid Mutual Fund.
Typically most liquid funds are okay, but it is still a good habit to check what it holds: a key Do’s and Don’ts of Debt Mutual Fund Investing.
Now take the next category in terms of risk. The ultra-short term funds. The lowest average maturity as listed at VR is 0.06 years (basically a liquid fund) and the higher maturity is 3 years!
The 3Y fund is 5 times more volatile than the 0.06Y fund! And to make things worse, the most volatile fund in the UST category is a fund that holds short-term gilts with an average maturity of 0.42Y.
The point is, the term "category" should not be taken too seriously when it comes to debt mutual funds.
This is the reason I have avoided referring to these and keep saying,
choose a fund with an average maturity much less than 1Y and one that invests in high credit quality (this includes short-term gilt or GOI fund).
Now have a look a the range of bonds that each debt fund category holds. This data is from a month or so ago. So the current data would be a bit different, but the essence is the same.
The horizontal axis is the average portfolio maturity. Each line represents one type of debt fund. The length of the line tells you the minimum and maximum maturities in that category. Notice how wide the line is and how one category overlaps with another.
The beads represent volatility in NAV. Notice how it gradually increases and beyond 1Y avg maturity, shoots up. Now focus on an average maturity of 0.001Y or 0.01Y. Notice that some funds for the same maturity have a higher risk. This is most likely due to credit rating variations. I need to dig deeper to confirm this though.
If you can understand the above plot, you will immediately understand whY I said the term category is pretty fluid and why it is difficult to narrow onto a category, even if we want an avg. maturity less than one year.
This is the reason I keep insisting that one should look at the scheme information document to understand where the scheme can invest. It is always better to choose a fund that will only invest in certain types of bond.
Take for example, the case of DSP BR Treasury fund. Its investment objective is:
The primary objective of the Scheme is to generate income through investment in a portfolio comprising of Treasury Bills and other Central Government Securities with a residual maturity less than or equal to 1 year.
Therefore the fund manager did not invest in longer duration gilt and neither profited from the recent gains, not suffered losses.
As part of my forthcoming robo-advisory toolkit, I intend to shortlist a few funds with a narrow mandate such as the above. Will post it separately. In the meanwhile, I recommend studying the scheme documents of "banking and psu" based debt funds in the ultra-short term category.
The debt mutual fund classification followed by Value Research (VR) is listed below. This classification is approximate and broad. While indicative of investment strategy and portfolio, always check with the latest scheme invest document to understand where and how the fund invests.
Short Term Gilt: Funds that exclusive invest in gilt (govt.) securities with average portfolio maturity up to 4.5-5.5 years (in the last year). This is a wide duration and volatility of a fund with 4-5 years average maturity would be much higher than funds holding much shorter bonds. Funds in this category can invest in long-term bonds if they expect rates to go down. The DSPBR Treasury Bill Fund is the only fund I would recommend here.
Ultra Short Term Funds: VR classifies funds with average portfolio maturity greater than 91 days to about 1 year. This classification applies only for the portfolio in the last one year. Such funds typically invest in bank, PSU and corporate deposits. However, you can see Kotak Banking and PSU Fund here with a current avg maturity of 3 years! And 13% of its portfolio has gilts. See what I mean?
Liquid Funds: Funds that invest in fixed income securities with a tenure equal to, or less than 91 days (this is a SEBI mandate).
Credit Opportunity funds hold bonds with medium to low credit quality with average portfolio maturity ranging from less than a year to a few years. Funds in this category typically hold the bond until maturity. That is they allow interest income to accrue without selling the bonds. However, the credit rating of the bonds can either go up or down resulting in sharp NAV upward or downward movement respectively. Debt Mutual Funds: Credit Risk and Interest Rate Risk Can Co-exist!
Debt Income: Funds this is category can be thought of as the equivalent of diversified equity funds. They can hold anything from cash, gilts, corporate bonds, bank or PSU deposits. They could further be classified into long-term and short-term income funds. The ‘income’ refers to a combination of interest income and capital gains due to interest rate or credit rating changes. There is no specific maturity band. It can be anything.
Debt Short Term: This is a broad category where the average portfolio maturity can be anything from under a year to about 4.5 years. The average credit quality also varies widely from AAA to A. Some of the funds in this category exclusive hold banking and PSU bonds. Investors who would like to avoid credit risk, but would like a small risk premium compared to gilt bonds can consider such funds. The current list has 2 funds well above this 4.5Y mark.
Dynamic Bond Funds: The funds have a mandate to shift to longer duration bonds (both gilt and corporate) when interest rates are expected to fall and to short duration bonds when rate are expected to increase. However, not many funds are truly dynamic and they tend to behave more like diversified debt funds. Although expected to have much lower volatility than long-term gilt funds, it is not the case. Do not invest in dynamic bond funds!
Fixed maturity plans (FMPs) are closed-ended debt funds. That is the fund opens for subscription during the new fund offer period and is closed to both new investments and redemptions until the maturity date. The NAV however, would be listed on each business day. The portfolio can be a mixture of corporate, bank and PSU bonds of varying maturity. The FMPs in principle can be sold and bought in the secondary market with a demat account. How to Select Mutual Fund Fixed Maturity Plans (FMP)
Open-ended FMPs are known as interval funds: Introduction to Interval Income Mutual Fund Schemes
Thet can be used intelligently: Smart Ways to Invest in Corporate Fixed Deposits
Gilt Medium & Long Term: Funds that invest exclusively in gilt bonds with average portfolio maturity above 4.5 years. This NAV of these funds will react sharply to interest rate movements – gain when interest rates fall. However, since interest rates are cyclic, these funds tend to lose what they gain when the interest start increasing again. Therefore they are used for opportunistic buying and selling.
Never buy long-term gilts. See why here. They are meant for trading, not investing.
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