When most financial planners or investment advisors recommend debt funds to their clients, it appears that they are suggesting an unpopular choice. Despite being highly rated by financial experts and SEBI-registered advisors, debt funds have seen net outflows in many categories in the recent few months. This trend raises the question: Why are investors choosing to withdraw money from debt funds and instead invest in other instruments?
Why Debt Funds Must Not Be Selected With Only Recent Performance
Perhaps the issue lies in the way many investors pick financial instruments, especially mutual funds. Short-term debt funds have returned just 4.37% over the past 1-year period, while government securities or gilt funds have given a return of only 2.85%. Moreover, data from the Association of Mutual Funds of India (AMFI), the mutual fund industry’s trade body, shows that in 11 out of 16 categories, debt funds saw net outflows, meaning that more money left the funds than came in.
If you had invested in debt funds, says a short-term fund, at the beginning of a year, you would have earned returns of just around 4.1-4.35%. But if you had invested in a bank FD, you could have earned at least 5%. In the case of gilt funds, returns were even lower, at 2.15% on average in recent years. These low returns may explain why investors are being drawn to fixed deposits, where returns are currently as high as 7%.
However, it is important to note that investors need to carefully evaluate the comparative merits of debt funds versus fixed deposits, and not base their decisions on past performance alone. A prudent investor will also look at performance but more in relative terms, and how consistent such relative performance is for a given fund. At Jama Wealth we have holistic measures that track credit quality, consistency of performance and expected yields as well.
How Debt Funds Differ from Bank Deposits
There is a key difference between the returns from debt funds and the rate of interest offered by bank FDs. A debt fund’s return is its past return. In contrast, a bank FD’s return (its rate of interest) is what the investor will receive in the future. Comparing past returns with future returns is not a prudent approach.
While a debt fund’s net asset value (NAV) moves in line with interest rates, a bank keeps changing its interest rates on new FDs offered to prospective investors, as and when interest rates move. This means that while a debt fund’s returns affect those already invested in them, a bank FD’s interest offering affects those who come in. Existing FD investors continue to earn the same rate of interest that they contracted at the time of investment.
Reinvestment Risk is Higher With Deposits
Then there is the reinvestment risk. This is the risk that an investor will be forced to reinvest their funds at a lower rate of return when an investment matures or a deposit is rolled over. This risk is generally higher with bank deposits compared to debt mutual funds in India.
In the case of bank deposits, the interest rate offered by the bank is fixed at the time of deposit, and if interest rates fall over the tenure of the deposit, the investor may not be able to earn the same rate of return on reinvestment. This can be a concern for long-term investors who want to maintain a consistent rate of return.
On the other hand, debt mutual funds invest in a portfolio of fixed-income securities such as bonds, which offer higher flexibility and liquidity than bank deposits. When a bond in the portfolio matures, the fund manager can reinvest the proceeds at the prevailing market interest rates, potentially providing higher returns to investors.
Moreover, debt mutual funds also offer a range of options such as growth, dividend payout, and dividend reinvestment, which can help investors customize their returns and manage their tax liabilities.
The Tax-Friendly Aspect of Debt Funds
This paragraph may be basic for most of our clients. But it is worth repeating. Debt funds in India are considered to be a tax-friendly investment option, especially when compared to traditional bank deposits. This is primarily due to the indexation benefit that debt funds offer. Indexation refers to adjusting the purchase price of an asset for inflation, which can significantly reduce the tax liability when the asset is sold.
In the case of debt funds, indexation can help to lower the capital gains tax liability, making them a more tax-efficient investment than bank deposits. Additionally, debt funds also offer the flexibility of investing in a diversified portfolio of debt securities, which can potentially provide higher returns than bank deposits.
Recent Interest Rate Cycles and Impact on Debt Funds
When interest rates go up, bond prices go down. Since the COVID-19 pandemic outbreak in 2020, central banks around the world, including the Reserve Bank of India (RBI), have started cutting interest rates to fight the impending economic slowdown. Bond yields fell, too, and bond prices went up. This benefited debt funds, with gilt funds recording returns of 3.7% and 4.06% in the quarters that ended March 31, 2020, and June 30, 2020, respectively.
However, interest rates started to go up in 2021. Inflationary pressures were visible in most parts of the world, including India, and market participants anticipated that it was a matter of time before the RBI resorted to reducing the money supply and hiking interest rates. Bond yields began to rise, and gilt funds gave returns of only 0.22% and 0.08% in the quarters that ended December 31, 2021, and March 31, 2022, respectively. Although government securities come with a sovereign guarantee, they can also be volatile as their market prices move up and down as interest rates change.
Risks with Debt funds Credit Risk
Investing in debt funds has become popular among retail investors because of the ease of investing, diversification benefits, and potential for higher returns than traditional fixed deposit products. However, it is essential to keep in mind that debt funds come with their own set of risks.
Credit Risk
One key risk is credit risk, which is the risk of default by the issuer of the debt security. This risk arises from the possibility of a borrower defaulting on their debt obligation, leading to a potential decline in the value of the fund’s portfolio. This risk is higher in low-rated debt securities and can lead to a significant loss of capital.
In debt mutual funds, credit risk is higher for funds that invest in lower-rated or unrated debt securities. These securities may offer a higher yield but come with a higher risk of default. Moreover, credit risk can also arise from the concentration of the portfolio in a single sector or industry.
To mitigate this risk, debt mutual fund managers typically perform a detailed credit analysis of the issuers and their debt securities before investing. They may also diversify the portfolio across different sectors, maturities, and credit ratings to minimize exposure to any single issuer or sector.
Additionally, investors can also monitor the credit quality of the fund’s portfolio and periodically review the fund’s holdings to ensure that the portfolio remains well diversified. A good SEBI Registered Investment Advisor will monitor this risk closely and advice clients in periodic reviews.
Liquidity Risk
Another risk that investors must consider is liquidity risk. Debt securities can be illiquid, and if the market conditions deteriorate, it can be challenging to sell these securities at a reasonable price. This can lead to significant losses for the fund and its investors. This risk arises from the possibility of not being able to sell the fund’s underlying debt securities quickly enough to meet redemption requests from investors.
The liquidity risk in debt mutual funds is higher for those funds that invest in less liquid debt securities such as lower-rated corporate bonds or those with longer maturities. This is because in a scenario where many investors redeem their units at the same time, the fund may not be able to sell its less liquid holdings quickly enough to meet the redemption requests, potentially resulting in a decline in the NAV of the fund.
To mitigate this risk, debt mutual fund managers typically maintain a certain level of cash or liquid investments in the portfolio, which can be used to meet sudden redemption requests. Additionally, investors should also be aware of the liquidity profile of the fund and understand the credit quality and maturity of the underlying securities before investing.
Interest Rate Risk
Interest rate risk is another important risk, which arises from the impact of changes in interest rates on the value of the debt securities. This can cause short-term fluctuations in returns, and investors must be prepared to hold their investments for the long term to mitigate this risk. In a scenario where interest rates rise, the prices of existing debt securities tend to fall, resulting in a potential decline in the net asset value (NAV) of the debt mutual fund. Conversely, if interest rates fall, the prices of existing debt securities tend to rise, leading to an increase in the NAV of the fund.
The degree of interest rate risk in a debt mutual fund depends on several factors such as the maturity of the underlying securities, the credit quality of the issuers, and the duration of the fund. Typically, funds with longer durations and lower credit quality have a higher degree of interest rate risk.
To mitigate this risk, investors can opt for debt mutual funds with shorter durations or funds that invest in high-quality debt securities. Additionally, investors should also diversify their portfolios across different debt mutual funds to minimize their overall exposure to interest rate risk.
Why Yield-To-Maturity Matters
That’s why a debt fund’s key is the Yield to Maturity (YTM), not its past returns. The YTM and expense ratio of a debt fund can together give an idea of the future returns of the debt scheme. An investor today can expect returns equal to YTM minus expense ratio.
So, for an average debt fund, the returns are primarily driven by the underlying interest rates, credit quality, and liquidity of the debt securities. The fund manager plays a critical role in managing the credit risk and interest rate risk of the portfolio by selecting the right securities and maintaining an appropriate mix of short-term and long-term securities, depending upon the market situation.
We now discuss the investment strategy that we recommends for clients, given the current state of the rates regime. We believe that the rates regime is stable and will remain so, and therefore recommends specific investment horizons for different types of funds.
For clients with a 1-year investment horizon or less, we recommend investing in ultra-short/money market funds. These funds are characterized by their short-term nature and low risk, making them a safe bet for those with a short-term investment horizon. Clients with a slightly longer investment horizon of 1-3 years are advised to invest in short to medium-term strategies. These funds typically have a slightly higher risk but also offer higher returns.
Looking ahead to the second half of 2023, we believe that there will be a significant shift in the rate regime. As the supply of government securities decreases, and the FED begins to turn its stance, long bond yields are likely to fall. As a result, investors can look at long bond/gilt funds, which are characterised by their long-term nature and higher risk, but also offer potentially higher returns.
Conclusion
To conclude, debt funds are a popular investment option for investors seeking to generate steady returns with relatively lower risk compared to equity investments. Investors should consider their risk appetite, investment horizon, and financial goals before investing in debt funds. They should also pay attention to the credit quality, interest rate risk, and liquidity of the securities held in the fund portfolio.
Overall, a good investment strategy focuses on matching the investment horizon with the appropriate type of fund, while also keeping an eye on upcoming changes in the rates regime to make strategic decisions about when to invest in longer-term funds. In addition, investors must keep in mind that debt funds are not risk-free and can be subject to various risks, including credit risk, interest rate risk, and liquidity risk. By understanding these risks and selecting the right debt fund, investors can benefit from the potential returns offered by these funds while minimizing their exposure to risk.
