Credit Risk and Duration Funds solve no purpose

Investors are often confused when it comes to investing in debt funds. Key reasons for this is that very few understand the cycles in interest rates and factors that impact returns in these funds and past experience is not good in long duration and dynamic bond funds. In every cycle investors came flocking into duration funds looking at past returns, only to get caught in the rising interest rate cycle leaving them with poor returns.

Other option which emerged in recent years is the Credit risk fund. These funds invest in lower credit rated bonds – mostly AA and A rated – and aims to generate higher yield (YTM) in the portfolio. Many retail investors have been investing in these funds. While the returns have been decent, there were certain instances where these funds have witnessed default and downgrades on their investments in bonds due to which investors made sub-optimal returns and some redeemed due to panic.

All in all investor experience in Duration and credit risk funds has not been satisfactory and in my opinion these funds don’t solve any purpose. Investors are better off by investing in low duration funds or short term funds.

Here are some statistics that will help you understand why Duration Funds and Credit Risk Funds aren’t great investment avenue for the risk they carry.

Duration Funds – High expense; volatile returns.

Below table shows returns of different category of funds.

Fund Category 1 Year 2 Years 3 Years 5 Years 7 Years 10 Years Avg. Expense Ratio
Low Duration Funds – Regular 6.06 6.74 7.27 7.94 7.90 7.34 0.80%
Short Term Funds – Regular 4.02 5.61 6.69 7.74 7.99 7.83 1.16%
Medium- Long Duration Funds – Regular 0.39 3.36 5.97 7.58 7.60 7.67 1.76%
Dynamic Bond Funds – regular 1.49 4.33 6.71 8.29 8.30 7.41 1.68%
Category average returns as on 27th Sep 2018 

If you notice over last 10 years medium-long duration funds and dynamic bond funds have under-performed Low duration and short term funds across 1,2,3,5,7 and 10 year period. Even dynamic duration fund has under-performed across period leaving aside 5 and 7 year period.

While some may argue that return in duration fund is lower as currently yields have gone up sharply, lets see the results when we compare performance for different dates using rolling returns.

Rolling return analysis (since 2005)

1 year rolling returns Medium – Long Duration Fund Low Duration    Fund Short Term Fund
Maximum 26.63 10.47 17.85
Minimum -3.38 4.93 3.45
Average 8.67 8.30 8.71
Negative returns instances 190 0 0
Volatility (SD) 5.97 1.41 2.90
3 year rolling returns      
Maximum 13.78 9.65 11.07
Minimum 3.39 6.90 5.97
Average 8.91 8.41 8.93
Negative returns instances 0 0 0
Volatility (SD) 2.26 0.91 1.10
5 year rolling returns      
Maximum 10.72 9.50 9.83
Minimum 4.03 7.03 6.90
Average 8.34 8.46 8.70
Negative returns instances 0 0 0
Volatility (SD) 1.23 0.67 0.55

If you see in the table above the average returns from all three category of funds are almost same but the volatility one has seen in medium-long duration funds is more than 2 times of Low duration and Short Term Funds. Short term funds have out-performed duration funds across 1, 3 and 5 year investment period. 

This means investors are better off investing in low duration and short term funds any day. There is no place for high duration funds that charge you high expense, give you lower returns with higher volatility most of the time.

Credit Risk Funds- High expense with credit risk

The story of credit funds is not different. They charge very high expense and carry high credit risk which seldom any investor understands. When a credit rating agency can get it wrong it is too much to expect from anybody else.

Below table shows returns of different category of funds.

Fund Category 1 Year 2 Years 3 Years 5 Years 7 Years 10 Years
Low Duration Funds – Regular 6.06 6.74 7.27 7.94 7.90 7.34
Short Term Funds – Regular 4.02 5.61 6.69 7.74 7.99 7.83
Credit Risk Funds – regular 4.33 6.27 7.58 8.61 8.43 7.62
 Category average returns as on 27th Sep 2018 

Looking at the table above you may notice that credit funds have under-performed in recent years and on 10 year period and have outperformed in 3, 5 and 7 year period. But the out-performance is not that significant if you consider the risk they take.

lets see the results when we compare performance for different dates using rolling returns.

Rolling return analysis (since 2010)

1 year rolling returns Credit Risk Fund Low Duration    Fund Short Term Fund
Maximum 12.63 10.47 12.50
Minimum 4.86 6.13 3.45
Average 8.84 8.92 8.79
Volatility (SD) 1.58 0.99 2.02
3 year rolling returns      
Maximum 10.67 9.65 10.86
Minimum 7.48 5.58 7.72
Average 9.05 9.09 9.07
Volatility (SD) 0.61 0.55 0.73
5 year rolling returns      
Maximum 9.52 9.50 9.83
Minimum 8.22 8.39 7.92
Average 9.02 9.08 9.04
Volatility (SD) 0.29 0.31 0.42

When we look at rolling returns in the table above the average returns from all three category funds is almost same. In fact low duration fund beats credit risk fund hands down and with much lower volatility.

 Risk in Credit Funds:

Fund Category YTM Expense Net YTM  AAA AA A SOV Others
Low Duration Funds – Regular 8.25 0.8 7.45 68 20 3 1 8
Short term fund – Regular 8.75 1 7.75 65 20 3 3 9
Credit Risk Fund – Regular 9.77 1.8 7.97 18 50 22 1 9
Average of category as on Aug end portfolio

As seen in the table above credit risk funds have almost 72% exposure into AA and A rated bonds. The most important point here is to analyse the net portfolio yield. Most credit risk funds are bought basis portfolio YTM which is very high compared to other funds. But if you deduct the expense from this you get the net YTM which in case of credit risk funds is not very high compared to short term funds. The net YTM of credit risk funds is just 0.23% higher than short term funds. For this 0.23% you get a portfolio with significant credit risk. Is this worth the risk? Obviously not!

Conclusion:

Investors should ignore credit risk funds and duration funds. They are better off investing in a good low duration or a short term fund.

As seen in the past performance (Rolling returns), both low duration fund and short term fund has generated similar returns and at times even outperformed duration and credit risk funds and with much lower volatility and credit risk.

Watch expense ratios carefully before you invest in debt funds. Compare them within their peers and make sure they are not way too high than the category average.

Watch credit quality carefully and don’t fall for higher portfolio YTM. See net YTM.

 

Happy Investing in debt funds!

 

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