[Debt Funds] No credit risk, please!

Investors in debt mutual funds have had a rough last couple of years. As credit risk surfaced in debt funds, starting with the ILFS fiasco to the latest Vodafone Idea story, funds shaved off not only the gains but also the principal amount, sending investors into panic mode.

Now you could be someone who has sworn to never touch debt funds ever again. Or, you might have narrowed your field with, “can I get something with NO credit risk in the portfolios?”

As of today, the only funds that don’t carry credit risk are the ones that invest only in government / sovereign bonds. Since such bonds have an implicit backing of the Government (Central or State), the repayment is assured (well, more or less).

Since these carry no credit risk, they usually carry a lower coupon too (remember risk & reward relationship), compared to say, corporate bonds. Current yields on Government Bonds are around 7% to 8%.

How can you invest in these NO credit risk bonds?

There are quite a few ways.

Buy the government bonds directly

You have an option to buy government bonds directly from the exchanges where they are listed, using your demat account. Fresh issues happen from time to time as well and you may participate in them as well.

For an indicative list of existing bonds, see this link from the BSE.

However, the liquidity of these bonds is a question mark. Volumes (for buying and selling) is not very high. So, unless you are willing to hold these listed bonds till maturity, you may be in for a surprise when you want to sell.

Another option is to buy debt mutual funds that invest only in Government Securities.

The Gilt funds and 10 year Constant Maturity Bond Fund are the categories you can look at.

The mandate of these funds is to invest only in Government Bonds. While the Gilt Funds can have investments across short, medium and long term, the Constant Maturity Funds invest in instruments with maturities with 10 years or more.

These funds follow a core and a tactical portfolio approach. The tactical portfolio is meant to manage the portfolio actively to benefit from the interest rate environment and generate extra returns.

Here’s an example. SBI Magnum Constant Maturity Bond Fund lists its investment strategy as:

“Investment in Central and/or State Government securities are considered to be free of credit risk. However the aim of the portfolio will be to make capital gains by actively managing interest rate risk.“

The investment objective of the scheme is “to provide returns to the investors generated through investments predominantly in Government securities issued by the Central Government and/or State Government such that the Average Maturity of the portfolio is around 10 years.”

This active management along with the interest rate movements may result in periods where funds generate a much higher return than the coupon rate of the underlying bonds.

As an example, take the portfolio below for SBI’s fund.

The portfolio has 3 securities with coupons ranging from 7.26% to 7.88%.

However, the annualised returns (trailing basis) of the fund for last 1, 3, 5 and 7 years are quite different, much higher, in fact.

How come? What magic happened here?

Well, the fund benefited from a falling interest rate scenario. Since there is an inverse relationship between bond prices and interest rates, the former tends to rise when the latter falls. As a result your fund value goes up and you get a neat capital appreciation.

Remember though, over longer periods such as 10 years or more, the returns are likely to moderate.

The Tax Benefit

An interesting proposition of these funds is that when you go for the growth option, it does not result in any cash flow to you unless you sell the units of the fund. No interest cash flow and hence, no income tax.

Even when you sell, your gains are categorised as capital gains. In fact, if you can hold on for 3 years or more, you get to benefit from long term capital gains tax, which is just 20% after indexation of cost. That tax shaves off only about 1% from the gross gains. So, instead of 9%, you might end up with 8%, post tax. Not bad!

With the mutual fund option, the liquidity too doesn’t remain a concern as you can buy and sell any time with the fund itself.

Yet another option is to buy a Gilt ETF or Exchange Traded Fund.

Now, the no. of options are currently limited in the ETF space and they may suffer from liquidity too. Hopefully that will change in the times to come.

Nippon India ETF Long Term Gilt is an option here. The primary investment objective of the scheme is to generate optimal credit risk-free returns by investing in a portfolio of securities issued and guaranteed by the Central Government and State Government. (Source: Scheme Information Document)

Remember, you can buy an ETF only on the exchange via your demat / trading account.

A word of caution – the volatility of govt bonds or funds

It looks like you may have already got excited about the prospect of investing in these bonds / funds / ETFs.

Well, before the performance numbers make your eyeballs pop out, see the chart below.

Do you see the yo-yo of the prices?

It is not a straight line as you would expect of a debt / safe fixed income, fund. There may be periods when the value may go down as well. It is not a fixed deposit or post office scheme.

So, what should you do?

Caution first. Don’t become greedy by looking at the past returns. Playing the short term can be very dangerous and cause wealth erosion.

If you are investing in Gilt funds, buy them for your long term portfolio and asset allocation only and limit their overall allocation to your portfolio.

If protection of capital at all times is your primary concern, just use safe liquid or ultra short term funds, which invest primarily in Govt Bonds.

Between you and me: What other NO credit risk investment options do you use? Do share in the comments section. If you have any further observations or questions, feel free to ask.