If you are debt mutual fund investors, then you may be aware of the news circulating for a few months with respect to certain companies credit downgrade or default in payment.
As of now, as per my knowledge, except Overnight Funds, Liquid Funds, and Gilt Funds, the majority of other categories of funds impacted to this news (few funds may not be impacted due to their exposure to such companies is NIL). This does not mean they are SAFE.
Today it may be because of DHFL, ZEE, IIFL or Vodafone but tomorrow it may be from some other companies.
You noticed that the reasons with respect to Vodafone downgrade are different than the other companies. However, at the end, it will impact the investors largely.
Credit Downgrade or Default Risk in Debt Mutual Funds – What are the alternatives?
In such a default or downgrade situation, what are the alternatives for our debt portfolio? Before jumping into understanding the available alternatives, I wish to share certain points with you.
# Credit Ratings are not constant-Yes, as you may be aware of how the credit rating changes and how it badly impacts your portfolio. Hence, never rely on credit ratings and invest.
# Never think the regulator will protect you-In many cases regulators open the eyes only when the incident happens. They tweak certain rules and then again go for sound sleep. Hence, never invest in debt funds just because there is a regulator who will take care of such default or credit risk.
# Never look for top holdings only-Many of us are under the habit of just looking at top holdings of the fund. However, your fund manager may be wisely holding certain low graded debt securities, which may not be part of top holdings. Hence, to make sure what the portfolio is, dig deep and review the complete holding of the funds.
# It is better to review the fund underlying portfolio once in a while-As you may be aware, based on the fund you have chosen, the fund managers hold the debt papers. Hence, there are situations where while investing the fund might have held all best debt securities. But later on, the fund manager might have invested in low rated papers. Hence, it is wise to cross-check the portfolio once in a while.
# Never concentrate on RETURNS alone-Never rely on just returns while choosing the debt funds. Higher returns in many cases may be due to the fund manager bet on low rated papers. Hence, a higher return debt fund does not mean the best fund.
# Never rely on STAR ratings-Exactly like credit ratings, these star ratings may also change as and when they wish. Hence, never choose a fund just because it is rated with FIVE or FOUR star.
# Your investment period must always be more than the average maturity– Many so-called experts suggest you that your investment period must match with the fund’s average maturity. However, a single default or credit risk may take more time to recover than the average maturity of the fund. Hence, make sure you must NOT follow this theory.
# Never concentrate on YTM-Many people think higher YTM (Yield to Maturity) means a higher return. But do remember that higher YTM indicates a higher risk. Hence, never be on wrong belief of concentrating on YTM.
# No Debt Fund is SAFE-Yes, it is a reality you have to understand. There was a case, where a Liquid Fund NAV dropped to around 9% in a single day (I have written a post on this and you can refer at “Is Liquid Fund Safe and alternative to Savings Account?).
The degree of risk varies from category to category. Hence, believing the particular category of the fund is risk-free means you are under wrong impressions.
# Reasons for DEFAULT or CREDIT downgrade may differ-Never be in a wrong notion that any one particular sector of companies debt papers may be risky and others are safe. Such a default or credit downgrade may happen with all sectors. Take an example of DHFL Vs Vodafone. Both are from different sectors. Both have different reasons for freefall. Hence, never be biased towards a particular sector.
After going through all the above risk factors, now you have to decide what are the alternatives for our debt part of the investment. Let me list them one by one.
1) Post Office Savings Schemes
Yes, there may be certain service-related issues. However, considering safety, I prefer these savings schemes as the best choice. It does not mean you must invest in them BLINDLY. Make sure the product may fulfill your needs. Choose wisely from the product ranges like a savings account, Term Deposits, MIS, SCSS, PPF or Sukanya Samriddhi Yojana Account, NSC or KVP.
Because Post Office Savings Schemes offer you 100% Sovereign Guarantee.
2) Bank FDs and RDs
The next level of products is Bank FDs and RDs. Open the FDs and RDs with nationalized banks rather than risky co-operative banks. Many people do in-depth research like which will offer them higher returns. Do remember, higher return again leads to higher loss.
Hence, prefer PSU Banks especially and if possible big private sector banks like HDFC or ICICI kind of banks.
3) Public Provident Fund or PPF
PPF is a wonderful long term debt product. Hence, always utilize this debt product to the maximum of your debt portfolio. Nowadays, even banks also offer you PPF and you can operate PPF online. Hence, greater comfort with better safety.
4) EPF and VPF
EPF and VPF are the best debt instruments you can consider for your retirement goal’s debt part. Use to the maximum as this product gives you safety, tax efficiency and higher returns than other debt products.
5) Overnight Debt Mutual Funds
Overnight Debt Mutual Funds are the safest debt funds among all categories of debt funds. Hence, use them for your few days to a few months’ parking requirements.
6) Liquid Funds
After Overnight Funds, the next category of safe funds are Liquid Funds. However, as I mentioned earlier the fiasco of one Liquid Fund, it is always better to be cautious while choosing the Liquid Fund. Check the underlying portfolio and take your call.
7) Arbitrage Funds
Many of us use Arbitrage Funds because of safety and tax advantage over other categories of debt funds. However, do remember that Arbitrage Funds can also hold around 35% debt instruments and another 65% in equity and equity-related instruments. Hence, be cautious on their 35% debt part.
8) Gilt Funds or Gilt Fund with 10 Years Constant Maturity
Gilt Funds simply avoid the risks of default and credit rating downgrade. However, depending on the average maturity of the fund, they are prone to interest rate risk. Hence, you may see the volatility in such funds too.
Gilt Funds definitely offers you relief from credit risk and default risk, but due to their change in the stance of the average maturity period, they may pose higher volatility. In short, it acts like a typical dynamic bond fund where the exposure is to Gilt papers. Hence, they may be volatile and if the fund manager call goes wrong, then it may impact your returns.
Hence, to avoid such things, prefer Gilt Fund with 10 years of Constant Maturity. Use this category of fund for goals that are long term like 10+ years or so.
Do remember that Gilt Funds hold around 20% in imperfect hedging to curtail the interest rate volatility.
Few points to note before selecting the recommended debt products
# Keep around 10% to 25% of your debt portfolio in Liquid or Arbitrage Fund to make sure that the fund is available easily for your rebalancing purpose of Debt to Equity.
# Consider the Liquidity issue while choosing the above-mentioned recommendations.
# Do remember that each of your debt investment products must match with your goal requirement. For example, use PPF only if your goal is more than 15 years. Same time, you can consider SSY as a debt part of your girl child education and marriage goals.
# Risk is everywhere. Even the money you are keeping in your savings account is also risky. Hence, managing the risk is the ART you have to learn.
Let me know if you have any new ideas.
Thanks for this informative post.
I was told by an investment advisory agent that gilt funds too may have default risk – if the asset management company goes near bankrupt then our gilt fund investments may be lost. I always believed that gilt funds are safer than FDs and are comparable to government bonds, PPF and postal saving schemes when it comes to safety of investment, i.e. they have the lowest default risk. Was the investment advisor incorrect or is it true that gilt funds are safe only as long as the asset management company is going well?
Dear Anonymous,
As per him then which is safe in mutual funds? I think he may be representative of some insurance companies.
Hi sir,
This person did not say that any mutual fund is safe. He first advised me to go for direct trading in certain stocks that would be recommended periodically by his AMC if we subscribe to some stock advisory plan, because this could yield higher returns than many good mutual funds in long term. When I told I was not interested in the plan, he advised me some insurance plan that invests some portion of premium in equity and is dynamic in its equity portfolio and so would yield not only an annualized return of at least 9% in the worst case, annualized over 15 years but would also be safer than gilt funds. When asked why gilt funds are unsafe, he said that if an AMC defaults then amount invested in gilt funds too would be lost. How true is that statement about default risk in gilt funds?
Dear Anonymous,
Whether he told anything about Insurance company default? If your fund is investing in GILT, then AMC as a custodian has the obligation to pay to the investors but not default. These are the guys who wish to sell something for THEIR OWN PROFIT. Stay away from such dangerous species.
Dear Sir, My query is reg SCSS. As per order amount of deposits in SCSS shall be restricted to the retirement benefits. Does it mean that non-salaried person and housewife of a salaried person can not invest?
Dear Pradeep,
If you are senior citizen as per the definition then you are eligible to invest in SCSS.
Dear Sir. I searched your blog for any articles on NSC but could not find it. I am already investing in PPF and getting 80C deductions from it. However for the debt component of my portfolio and for purpose of 60 – 40 allocation, i want to further invest in NSC. As advised by you I have invested 10% in Arbritrage debt funds for rebalancing purpose in future. My query is because i am using PPF for 80C, is interest taxable for NSC for each of the 5 years? I am confused as several articles say that you do not have to pay tax on interest for the first 4 years but have to pay in 5th year. What difference will that make? I mean in the 5th year of withdrawal, the interest income will be quite high right? Hope I have been able to put forward my query clearly. Thanks
Dear Vikas,
If your investing in NSC is for debt purpose, then why not use Liquid Fund or same Arbitrage Fund? NSC comes with lock in. Yes, there are two options to declare the interest-1) On yearly basis 2) at maturity. Both are fine.
Dear Sir. Thank you for your response. The recent developments in debt funds have prompted me to think if i should divide to 1) Not So Safe Instruments (Equity) and 2) Completely Safe (Debt). While there will be lot of churning and analysis in the 1) part, I want to create a portfolio for the 2) part which is totally away from such events. So i am revamping my portfolio to 60 – 40. The 60% part will be Equity Mutual funds (Hybrid, Multi cap and one aggressive possibly Mid cap). The balance 40% i am trying to ensure that i do not lose sleep or ever need to thinking what is happening for it. I am already investing in PPF and now I am thinking of building NSC and possibly little % of physical gold. Correct me if my thinking is wrong please. This is for my retirement porfolio which is 10 to 12 years away. Also I was thinking of creating ladder for NSC by investing X amount each month in such a way that I will get guaranteed income each month in golden years. Thanks. Vikas
Dear Sir. Let me also add that reading the articles mentioned in your blog of investing in safe instruments for debt component of the portfolio has largely influenced me to this thinking. Thank you for the same. The whole idea is out of Rs 100.00, Rs 40 will always be mine regardless of what is happening in Equity funds world. Thanks again. Vikas
Dear Vikas,
Enhance PPF itself if possible, use liquid funds like Quantum Liquid Fund or use FDs of your choice. One way you are saying you are investing in NSC for asset allocation purpose and in another way you are saying to get guaranteed income each month. Please first be clear with what you want.
Thank you Sir. I meant guaranteed income 10 to 12 years from now after retirement. Investing X amount in NSC will mature in the next 5 years. Again thought of reinvesting the maturity amount for further 5 years. Then each month after 10 years (for the next 10 years) i will get guaranteed income from NSC as one NSC will get matured every month. I am self employed so no pension, hence this thought . Thanks Vikas
Dear Vikas,
For 10 to 12 years of your requirement, why you need such high and illiquid debt part as of NOW?
Sir, why do you recommend liquid funds for long term debt allocation when we get slightly better returns by investing in Short or Ultra Short term debt funds please? Thanks
Dear Vikas,
Check how the mutual fund companies played with other categories of funds by taking undue risk. In one way you are looking for NSC for safety and in another way you wish to take SLIGHTLY HIGHER RISK by exposing to Short and Ultra Short Term debt funds.
Dear Sir. Thank you. I wanted your insight which i now understand. Possibly I was misled or wrongly understood that Liquid funds are only for people who want to park their surplus amount for few months. Never realized that they can also form as the debt component for long time portfolio. Regards Vikas.
Dear Vikas,
You can and in fact I always consider Liquid Funds for my client’s long term goals also.
Sir. What are your views on Franklin Savings Fund (Money Market). Can one invest in this fund for rebalancing purpose ie from Debt to Equity? Thanks
Dear Vikas,
I stick to Liquid Fund and Arbitrage Funds.
Thank you so much Sir. With this, I end my discussion on this topic. When learned minds go out of the way to help beginners like me, it certainly helps. God Bless. Vikas
Dear Vikas,
Pleasure 🙂
I never invested in such things right now but once I heard about Post Office Savings Scheme from my parent…today I understand why they preferred. Because it is more safer then all other alternatives.
Thanx for sharing such great alternatives.
Dear Ajeet,
Pleasure 🙂
Is VPF eligible for 80C benefit upto 1.5lacs?
Dear Dipak,
Yes.
Hi sir,
You have said “Credit Ratings are not constant”, but I invested because they do research and analysis, before rating. it can be one factor before investing can’t completely ignore it.
Dear Ankit,
Yes, they do research, analysis and they can CHANGE TOO.