My Tenth Cent

In Part 1 and Part 2 of this series we have given a very good overview of debt mutual funds. We have covered the dynamics of debt mutual funds, key risks and the various types of debt mutual funds. 

This is the concluding part of the series. After having covered the basics we come to the most important question. 

What strategy to adopt when investing in debt mutual funds and which funds to invest?

But before we jump into this question, we should spend some time on the lessons from recent credit crisis. Because these lessons are a very integral part of the investment strategy.

Lessons from recent credit crisis

For a long while from 2005 to 2015, debt mutual fund investors had no reason to worry. The so called, credit risk existed only on paper. The defaults were far and few. Fund managers kept on getting more aggressive. But judgement day was around the corner. 

The last 3 to 4 years have seen a slew of high-profile defaults that have shaken the belief in debt mutual funds. Franklin Templeton shut down some of its debt mutual funds. This is probably was the lowest point in debt mutual fund credit crisis saga.  

2015 onwards we have seen many high profile defaults such as below. We will cover each of these defaults in detail in another series soon. 

1. ADAG Group
2. Altico
3. Amtek Auto
4. Ballarpur Industries
5. Café Coffee day 
6. DHFL 
7. Essel Group 
8. IL&FS 
9. Sintex 
10. Yes Bank

Many mutual fund schemes got badly hit by these defaults. Some of the funds had to suspend redemptions, which is an absolute killer for an investor. This is particularly devastating for investors who invest a very large corpus in a single fund. 

So what are the lessons that we can take away from these defaults and fund wind ups?

I have given below a quick summary of the 5 lessons. You can read this in detail here in a separate article on this website. 

1. Stick to safe fund houses

It is interesting to note that out of the 30+ fund houses, IDFC, HDFC & Axis have managed to keep their head above the water. ICICI & SBI closely behind them. 

2. Don’t chase returns in the case of debt mutual funds

The high returns that your fund manager may be delivering could be a result of going down the credit chain. In India when a credit goes down it is very difficult to exit the position.  This is the genesis behind the Franklin Templeton saga. 

So play safe in debt mutual funds and take risk with your equity mutual funds. Pay attention to the portfolio quality of your mutual fund scheme. Don’t just choose the highest returning fund when it comes to debt funds. Focus on funds with largely AAA portfolio. 

3. Stick to fund schemes with a reasonable size

The larger the debt mutual fund scheme, the better the ability to absorb losses. 

If a mutual fund scheme is very large, then an INR 100-200 crore default won’t really cause a crisis. The mutual fund manager should be able to absorb it and move on. You will have a quarter of sub-optimal returns, that’s about it.  But if the mutual fund scheme is small then it can lead to redemption pressure. This can soon precipitate into a crisis.  

So focus on large debt funds. Bigger the better.

4. Don’t concentrate your investments 

Do not concentrate your investments into 1 or 2 debt mutual funds. If things go wrong, there is a risk of shutdown of the mutual fund scheme. 

Spread your investment across 5 to 6 funds investing not more than 15 – 20% of the corpus in one fund. 

5. Don’t panic or shy away from investing in debt mutual funds.

Have you got scared of defaults and exited debt mutual fund investment? Have you moved your money into fixed deposits? This is an extreme move to my mind. 

Yes there have been many defaults. But these defaults are still a fraction of the funds outstanding under debt mutual funds. When you invest on a long term basis a quarter or two of lower returns is not going to hurt you. You need to avoid getting caught in a Franklin Templeton situation. The lessons given here should help in that.

Now lets look at the strategy for investment in debt mutual funds.  

Strategy for investment in debt mutual funds

I have outlined below the strategy that I find most sensible: 

1. Stick to funds from the safe fund houses i.e.  Axis, IDFC, ICICI & HDFC.  
2. Category 2 funds are all you need. Pick up 4 to 5 of the category 2 funds from these fund houses. In case you are wondering what is Category 2 ? we have covered this in detail in Part 2 of this series.
3. Are you a person with a higher risk appetite? Are you looking to deploy funds which you don’t need in the next 7 to 10 years and would like an extra 2% return?  Then  for 20% to 30% of your debt funds portfolio you can add well rated Credit Risk Funds or Long Duration funds.
4. Fixed deposits for emergency funds / short term (less than 12 months). 
   • Fixed deposits for emergency funds because safety takes priority for short term needs.  We can have fixed deposits spread across 2 or 3 banks – government or large private or foreign banks. If you want to know the 3 key aspects regarding fixed deposits, then read the chapter “Fixed Deposits” in the book ““Road To Financial Freedom – Ten Lessons To Prosperity”. You can download your free copy from the link above. 
   • You may still want to place emergency funds in mutual funds. It may be because you are in a high tax bracket and fixed deposits are not tax efficient. In this case Category 1 for money you need in your hand within 1 to 2 days of redemption. Category 2 funds for money which you are okay to receive in 4 to 5 days of redemption.  
   • You can follow the article: “Good Debt Mutual Funds To Invest” to know more about which funds to choose.  

Conclusion

I hope this comprehensive 3 part series have given you a full perspective on debt mutual funds. I will soon prepare a ready reckoner check list which summarizes all the action points. This check list can be your quick guide for investment into debt mutual funds. You can download and print for ready reference. 

You can also watch our video on “4 Tips to Choose the Right Debt Mutual Fund” on our YouTube Channel: