19 Jul 2020

Choosing a debt mutual fund

When I subscribed to SIPs in Kuvera recommended funds, I had no idea what those funds were, or how to choose one. Kuvera recommends Nippon India Liquid Fund for the debt portion of one’s portfolio. After starting the SIP, I learned how to evaluate mutual funds. Soon I had the revelation that picking equity funds is much easier (big thanks to the existence of Index Funds) than picking the right debt fund(s).

I slowly learned how to find out how much risk a debt fund is taking. Chasing returns is generally a bad idea, but choosing debt funds based on returns is a particularly bad idea. The way I invest—and most of us do—is to use the debt portion of the portfolio for stability while using the equity portion to bring in earnings/growth. Taking risks in debt funds for the sake of getting better returns is simply forgetting why you have an equity/debt split to begin with. Nevertheless, I decided to get better returns from my debt portfolio by selling off all my liquid fund holdings and invest in L&T Ultra Short Term Fund instead.

I chose the L&T fund because it has a high AUM; hasn’t had any significant credit incident; invests only in debts maturing in < 12 months, true to its label; and invests only in top-rated debts. I like PGIM India Ultra Short Term Fund too, but the PGIM fund’s low AUM (₹87 crores vs L&T’s ₹1,960 crores) scares me a bit. After choosing the L&T fund as the debt fund for my portfolio, I still had some discomfort… I was wondering if I should have chosen a different debt fund instead (to get better returns, of course!).

I read the definition of other debt fund categories, but that didn’t quite tell me whether they are better than ultra short term funds or not. Today, I downloaded the latest L&T fact sheets and looked at every debt fund they offer.
  • Money Market Funds will invest only in money market instruments. They won’t invest in other debts such as non-convertible debentures or sovereign debt, etc. Although money market funds seem to get a better return, the debt is concentrated and hence the risk is higher. (Interest rate risk is comparable to ultra short term funds, though, given < 12 months maturity.)
  • Banking and PSU Funds will only lend to banks and PSUs. The returns are quite attractive, but the maturity is much longer (about 5 years) and the one fund I looked at looks pretty volatile. Definitely not a great choice to bring in “stability” to your portfolio.
    L&T Banking & PSU Debt fund's past 3 years return graph shows volatility.
  • Short Term Funds, Low Duration Funds, etc invest in debts with a longer maturity period, so they will be volatile too. Credit Risk Funds do not, as the name suggests, bring stability to one’s portfolio. (I wasn’t tempted to invest in these anyway.)
Overall, I think this was a good exercise. My debt fund isn’t earning eye-popping returns, but now I know why I don’t want to invest in other fund categories. They are just too risky. I still stand by my choice to switch from Liquid to Ultra Short Term, though. Liquid seems too conservative. I am okay to take a little bit of risk.

It must be clear by now: there’s no one fund that works for everyone. Understand the risks each fund is taking and consider if you’re comfortable with that risk. That’s the only way to choose a fund that’s just right for you.