How to select the right debt mutual funds for your portfolio: Part 2

In our previous post, How to select the right debt funds for your portfolio – Part 1, we discussed how to select the right debt funds based on your investment tenure. There is a relationship between investment tenures and risk preferences. Shorter the investment tenure, lower is the risk expectation. However, even for the same investment tenures different investors may have different risk preferences and return expectations. In this post we will discuss, how you can select debt funds based on your risk / return expectations.

Risk appetite, in this context, is the need for capital safety versus higher returns. For some investors capital safety is of the highest importance, even at the cost of returns. For example, Rakesh has accumulated funds for making the down payment for property purchase. He has begun the search process and he has short-listed some properties. It may take him a few weeks or a few months to finalize the property, negotiate the price, get a loan and complete the purchase.

Where should he invest his funds for making down payment? For Rakesh, capital safety and liquidity are of the highest concern because his main goal is to buy the property; the return he gets from his accumulated funds for a few weeks or months is simply extra income. Rakesh should therefore, invest his accumulated funds in a very safe and highly liquid debt fund. Rakesh invests his money in a liquid fund.

Let us now discuss a situation, where returns are important. Ramesh has been saving for his daughter’s college education through systematic investment plan (SIP) in a diversified equity fund. Three years before his daughter goes to college, Ramesh decides that he cannot expose his savings for daughter’s education to the vagaries of the stock market; a severe bear market can easily wipe off a big portion of Ramesh’s accumulated investment. So Ramesh switches from equity to fixed income. While capital safety is important for Ramesh as well, he wants to get good returns also. He has three years till his daughter goes to college and the more money he can accumulate, the more he can spend for his daughter. Therefore, Ramesh is willing to accept some short term volatility in order to get higher income from this investment. Ramesh invests his money in a long term debt or income fund.

Nature of risk in fixed income investing

Let us spend a few minutes understanding the fundamental nature of risk in fixed income investing. There are basically three kinds of risk in fixed income.

• Interest rate risk:

  Interest rates are related to bond prices. Bond prices increase with decrease in interest rate and decrease with increase in interest rates.



• Credit risk:

  Credit risk in the context of debt funds is the impact of change in credit ratings on bond prices. Bond price will fall if credit ratings worsen and rise if the ratings improve



• Re-investment risk:

  Re-investment risk refers to risk of re-investing bond maturity proceeds at a lower yield than before.

Let us now discuss how we can avoid these risks. Interest rate risk can be avoided by holding bonds till maturity (as explained in our post, How to select the right debt funds for your portfolio – Part 1). Credit risk can be avoided by investing in Government Securities or highly rated (AAA, AA etc.) corporate bonds. Re-investing risk can be avoided by matching your investment tenure with the bond maturity or in the case of debt funds, the average maturity. You must remember however, that risk and return are related. If you want to avoid risks, you will be giving up on returns.

Selecting debt funds based on risk appetite

• If you have to redeem your investment,partially or fully, at short notice, then you need high degree of capital safety and liquidity. Money market mutual funds are safest and most liquid debt mutual funds. Money market rates, though aligned to overall interest rates in the market, are very little affected by changes in longer term yields in the short term. Credit risk is minimal because only issuers of highest credit quality are able to access money markets. Since the tenure is very short term, there is no re-investment risk.
  
  If you think, you may have to redeem your investments within a few weeks or months then liquid funds are the best investment option. Liquid fund is a much better option to park your funds for a short period than your savings bank account. They offer very high degree of capital safety and liquidity. In the last 5 years, liquid funds gave negative weekly returns only once, in 2013 that too in extra-ordinary global monetary circumstances, when the Federal Reserve in the US began to taper its bond purchase programme.
  
  If you think, you will not need the money for the first three or four months after investment, but anytime afterwards, then ultra-short term debt funds are the best investment choices. Ultra-short term debt funds are money market mutual funds and very similar to liquid funds in terms of risk characteristics. They usually give higher returns than liquid funds, but can have some very short term volatility in returns.


• If you want high degree of capital safety but do not need money at short notice, then you can afford some very short term volatility, provided the risk over your investment tenure is very low. Short term debt funds with the highest credit quality are ideal for risk-averse investors over one to two year investment tenure. These funds hold the bonds in their portfolio to maturity and hence, there is very little interest rate risk. By selecting debt funds with very high credit quality, you can avoid credit risks.
  
  Debt funds with high credit quality have their portfolios invested in mostly Government and AAA or AA rated corporate bonds. Government bonds come with sovereign guarantee and there is no risk of default. High credit ratings assigned to corporate bonds signify balance sheet strength of the issuer and low risk of default. Re-investment risk can be avoided by matching your investment tenure to the average maturity / duration of the fund. You can get information on the fund maturity profile of debt fund schemes in the monthly factsheets published by the AMCs. You can download monthly factsheet of all AMCs by going to our Form Download Centre.


• If you have a longer (2 years or more) investment tenure and are not bothered by short term volatility, then you can invest in income funds to get higher returns. You should understand the concept of risk in the context of investment tenure in fixed income investing. By risk, we are referring to interest rate risk here, because you can avoid credit risk by selecting a fund whose credit quality is very high and re-investment risk is irrelevant because your investment tenure is likely to be less than bond maturity period.

Let us now understand interest rate risk from the perspective of a long term income fund investor. Debt fund investors should know that, income funds (or long term debt funds) are subject to interest rate risks. In the last three years, income funds gave an average nearly double digit returns (please see our research tool, Mutual Fund Category Monitor). You can argue that, in the last three years we had a benign interest rate regime. But what about the last 5 years?

In the last 5 years, we also have periods of rising interest rates. In the last 5 years, income funds gave an average 9% returns (please see our research tool, Mutual Fund Category Monitor). You may say that, what if I do not have a 5 year holding period? The lowest 3 year annualized rolling return of average income fund category over the last 5 years was 7.3%. This was the worst case scenario for average income funds in the last 5 years for investors with a 3 year holding period.

This is still better on a post tax basis for investors in the highest tax bracket, than the best FD interest rate over a three year period, given the tax advantage of debt mutual funds over fixed deposits. By the way, the best 3 year annualized rolling return of average income fund over the last 5 years was nearly 12%.

Why are income funds able to give good returns over a long period? The answer is simple. Over a long period of time, interest rates do not move in unidirectional manner. A period of rising rates will inevitably be followed by a period of falling rates. Smart investors, who are able to invest at the peak of the interest rate cycle, will benefit the most from income, but over a sufficiently long period of time, most investors can benefit from good income funds, irrespective of when they invested. Continued to Part 3