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How to choose a debt mutual fund?


14 Apr 2021 - Contact Sayan Sircar
14 mins read

Choose a debt mutual fund without breaking your head over it.

Original: 14-Apr-2021

Updated: 07-Jun-2021 with new SEBI debt fund classification, 21-Dec-2021 with category returns table

Choosing a Debt mutual fund

A debt fund has a single purpose in a portfolio: reduce the overall risk and provide a small amount of return. The purpose of having debt as a part of the overall asset allocation of a goal is to stabilise the portfolio risk. It is extremely risky for DIY investors to chase returns from debt in their overall portfolio since debt funds can crash drastically like this.

Debt fund behaviour

There are 16 categories of debt mutual funds in India that makes choosing one very difficult. The onus has been put on the investor to understand how these work and perform the very difficult task of choosing one suitable for the goal.

In this article, we present an easy-to-follow 3-step framework to cut through the clutter and choose funds that meet the stated objective.

This article assumes that you know what a debt fund is: a mutual fund that invests in one or more bonds issued by one or more different companies or the Government of India/State Governments. Entities that raise money via bonds are called issuers.

Table of Contents

Quick primer: risk and return in debt funds

Like all mutual funds, and unlike Fixed Deposit (FD), debt fund returns (and principal) are not guaranteed and returns can fluctuate continuously.

Debt fund risk (and return) come from two main sources:

Credit risk

This determines how good the underlying bond is in terms of the issuer’s capability of paying back the regular interest (called a coupon) and the money borrowed (the principal) of the bond.

Issuers are rated by Credit Rating agencies (like S&P, Moody’s, Fitch, CRISIL, Indiaratings etc) and given a scale like AAA (best quality), AA (lower than best), to D (worst quality - unable to pay back the money borrowed). Higher the credit rating (AAA or SOV - for the government), lower is the coupon and lower is the credit risk.

For our framework, we stick to a mix of SOV/AAA/A1+/Cash only (same as SEBI’s new Class A i.e. CRV >= 12 categorization, explained below)

Interest rate risk

This affects the prices of bonds already in the market.

If an existing bond offering a 7% coupon is pitted against a new bond that got offered at a lower coupon of 6% (interest rates are falling) then the existing bond is more desirable and so is a debt fund holding these older 7% bonds. The reverse happens if interest rates rise in the economy - debt fund NAVs fall. This metric, for measuring interest rate risk is called Modified Duration, is available for all debt funds and measures the rate of change of the portfolio NAV due to changes in interest rates

For our framework, we will stick to a duration of up to 1 which effectively means that for every 1% rise (fall) in interest rates, the fund NAV will fall (rise) by 1%. The debt fund categories that satisfy this criterion are overnight, liquid, ultra-short, low duration and money market funds. This is the full list from SEBI. The new June 2021 (details below) debt fund classification by SEBI defines Macaulay Duration of less than or equal to 1 year as Class 1. This recommendation is in line with the SEBI definition since Duration < Macaulay Duration for all debt funds.

In general, funds with large AuM increases diversification. There is no role of star ratings or past performance in choosing a debt fund.

How to filter funds for these two criteria

SEBI Debt fund matrix Jun 2021

SEBI on Jun 07, 2021, amended the regulations for classification of debt funds to better allow investors to understand the risks when choosing one. These new classifications will be effective December 2021.

As per the new SEBI criteria, stick to debt funds with:

  • Maximum Credit Risk of Scheme equal to Class A (CRV >= 12) - relatively low credit risk
  • Maximum Interest Rate of the scheme equal to Class I: (Macaulay Duration <= 1 year) - relatively low-interest rate risk
  • The funds should be DIRECT GROWTH funds only

One word of caution: The SEBI criteria refers to the maximum risk that the funds can take. Also the credit and interest rate figures are an average value. This means that there could be bonds in the portfolio with risk numbers worse than the average without affecting the average. It is therefore recommended that the investor carefully looks at each bond in the portfolio on regular basis to ensure that they are individually within the risk limits of CRV>=12 and MD<=1.

For example, a hypothetical portfolio of 90% in 91-D T-bills and 10% in 10 year GSec will have MD<=1 at a portfolio level but the interest rate risk will be higher than a fund which invests 100% in 91-D T-bills.

You can get bond portfolio details (for both credit quality and duration) via portals like Valueresearchonline. For each fund, look for these metrics:

  • Modified duration (D)
  • Average Credit Rating

Another two metrics that you need to note:

  • Yield to Maturity (YTM)
  • Expense ratio (TER)

How much return can be got

Estimated return from the debt fund in 1 year:

(YTM - TER) - D * ChangeInRates

where, ChangeInRates > 0 for increases in rates. The minus sign in front of D signifies that the return falls when rates rise and vice versa.

For some typical numbers,

YTM = 4%, TER = 0.2%, D = 0.16, Change = .5%,

expected return = 4 - 0.2 - 0.16 * .5 = 3.72% in 1 year before taxes.

Your objective should be to maximize this expected return within the credit and interest rate limits mentioned in this framework.

Warning: When filtering on yield (and TER), do not get enticed with higher-than-average yields. Critically evaluate the credit risk of the portfolio (and read the scheme document) as well to see that you are comfortable with the constituents of it, and how they have evolved in the past (debt fund portfolios are disclosed every fortnight as a requirement from SEBI).

Here is a table of historical data for debt funds (and Arbitrage funds) from 2011-2020:

(click to open in a new tab)
Debt Fund Returns

Do these debt fund categories beat inflation?

Category Post tax return Return over inflation
Liquid 7.5% 0.5%
Money Market 7.9% 0.9%
Overnight 7.0% 0.1%

We have performed a detailed analysis of debt fund category returns vs inflation in this post: Can debt funds beat inflation?.


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A note on taxation

Debt fund taxation is different from equity:

  • Short term capital gains tax: same as investor’s own slab (10/20/30%) if sold before 3 years
  • Long term capital gains tax: 20% of the profits after indexation if sold after 3 years

It is therefore recommended that debt funds be typically used for goals more than three years away for the sole purpose that before 3 years, and FD gives more predictable returns and is taxed the same. Read more: Mutual Fund vs Fixed Deposit - where should you invest?

When held for more than 3 years, thanks to indexation, the tax on debt funds can be significantly low compared to FD. More details on debt fund taxation is covered in this post.

Additional options for post retirement debt instruments are covered here:

A note on generic advice

A common advice found in multiple places regarding investing in debt funds is to:

match your intended investment horizon with the portfolio duration

This is not terrible advice per se, but it fails to highlight two risks:

  • higher the portfolio duration, more will be the fluctuations in the debt fund NAV. This can be an opportunity to rebalance with equity if the investor is disciplined enough but can be disastrous if the portfolio is left to float and there is a rate increase just before money is needed
  • the investor does not control the duration of the fund. As time passes and the goal comes closer, it will be difficult to keep shifting, due to taxes, to lower duration funds. Roll-down funds, which over time bring down the duration of the fund, do exist but those are difficult to identify and usually not a part of the overall investment objective of the fund

Due to this reason, it is a good idea to keep the duration of the fund low, i.e. below a year to avoid both these risks. This concept is addressed in more detail in this post: Should you match debt portfolio duration with goal duration?

Which categories should be generally avoided

We will refer to the category returns table above for some of the data.

  • Gilt funds: While this category has zero credit risk, these funds have a large amount of interest rate risk. In 2020, these funds gave huge returns due to falling rates but run the risk of large losses when interest rates rise. Investors should continuously monitor interest rates and their asset allocation if they decide to invest in Gilt funds. If the investor is able to accept the volatility of interest rates movements and can rebalance as per their plan, then Gilt mutual funds can be considered if the goal horizon is 10 years or more.
(click to open in a new tab)
Yield and returns in a gilt fund

The recent (2019, 2020) high returns of gilt funds is due to falling interest rates which can abruptly reverse any time and lead to heavy losses. Since short term interest rates can be volatile, so can gilt fund NAVs. Recent returns of debt funds do not predict future returns in any way (see the 3rd panel above).It is upto the investor’s risk appetite to try to profit from this volatility or else avoid this category altogether.

  • Banking and PSU funds: This category has very less credit risk but can have interest rate risk. Investors should note the modified duration of this category before investing and avoid if they are uncomfortable with the value.

  • Corporate bond fund: These funds will have more credit risk than Gilts by definition and can have any amount of interest rate risk.

  • Fixed Maturity Plans (FMP): These are closed-ended funds with a fixed maturity which prevents investors from exiting in case they are unhappy with credit or interest rate issues with the bonds. These funds are exchange-listed but thinly traded making exit difficult. These are generally structured to highly tax efficient.

  • Floating rate funds: these funds in theory should protect against changes in interest rate risk since their duration is small and underlying coupon payment rates change in sync with interest rates in the market. In practice, not a lot of floating-rate bonds are issued and as a result, all floating rate funds use swaps and other derivatives to simulate, imperfectly, the benefit of floating rates

  • Credit risk funds: These funds have the highest range of returns (>13%) and is the only category with average negative minimum returns. The risk/reward ratio is among the poorest with post-tax return over 10 years lower than 12 other categories with lower risk.

Bottom line: step-by-step process

Pre-requisite: Goal > 3 years

  1. Category of fund: overnight, liquid, ultra-short, low duration or money market funds only with Macaulay duration <= 1 year (alternatively modified duration <= 1 year) [Class I: (Macaulay Duration <= 1 year) as per SEBI]
  2. Credit quality of portfolio: mix of SOV/AAA/A1+/Cash only [Class A (CRV >= 12) as per SEBI]
  3. Maximise the expected return after factoring in YTM, TER, modified duration and the portfolio quality
  4. Only invest in DIRECT GROWTH funds
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This post titled How to choose a debt mutual fund? first appeared on 14 Apr 2021 at https://arthgyaan.com


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