Let The Debt Fund Investor Beware
An ever increasing number of Indian investors are slowly beginning to wake up to the importance of having debt mutual funds in their portfolios. They now realise that debt mutual funds offer them another investment option beyond traditional bank deposits as far as relatively lower risk investment products are concerned. Participation by individual investors in the wider debt markets in India is also steadily increasing. And this is understandable since debt funds work out to be more convenient in terms of liquidity and tax efficiency for investors, compared to holding a set of individual bonds.
But even so, most investors in debt mutual funds still lack clarity and have a number of misconceptions with regard to the nature of debt mutual funds. This could lead to the development of unrealistic expectations from such funds, in terms of returns they generate, the extent to which they manage risk in portfolios, and their overall suitability for portfolios. This would ultimately lead to disappointment and suboptimal performance for investors. So today, I am going to focus on clearing common misconceptions surrounding debt mutual funds and show what we should actually expect from our debt mutual funds. (I have covered the basics of picking debt mutual funds in one of my earlier articles The Debt Mutual Fund Checklist. So I will not be discussing that aspect here).
One of the foremost reasons why debt funds have gained popularity among investors is because they are seen as a replacement or a substitute to traditional bank deposits. For any two investment products to be replacements or substitutes for each other they must both have identical, or at least similar risk and return profiles. Now a bank deposit is a fixed interest bearing non market linked instrument, making it almost risk free. A debt mutual fund is a market linked instrument with a market value that fluctuates regularly, and such changes in value can be tracked over a period of time.
This naturally means that debt mutual funds do carry a certain degree of risk and therefore compensate investors with a relatively higher return compared to bank deposits. This clearly means that debt mutual funds are not perfect substitutes or replacements for bank deposits. They are simply a more tax efficient avenue for those in the 20% and 30% tax brackets to gain exposure to debt over periods of more than 3 years. This is because they are taxed with the benefit of indexation after 3 years and allow investors to completely avoid being taxed until the point of sale or redemption. This is reflected in the graphic that follows.
One of the most popular bits of financial theory that is propogated is that bonds and debt mutual funds lose value as interest rates rise, and vice versa. This is largely true in the fundamental sense, and is one of five fundamental bond valuation theorems.
But, the bond market in India today is progressively becoming deeper and deeper due to increased participation in the bond markets from a wider variety of players. Therefore, the Indian bond markets are now subject to a much higher degree of speculation. And NAVs of debt all categories of debt mutual funds (including more stable varieties such as liquid funds and overnight funds) are bound to be affected by this. This means prices of market linked debt instruments are highly likely to be driven as much by speculation as fundamentals in the years and decades to come. Investors must therefore not look to tie their operations and assumptions to fundamental financial theory too strictly.
Debt is traditionally seen as a counterweight to equity owing to the opposite nature of the two asset classes and the consequent low correlation between them. This leads investors to develop the perception that their investments in debt products would insulate their portfolios against a downturn in equity markets. While it is true that debt is relatively less volatile than equity, debt as an asset class can never perfectly insulate a portfolios against a drop in the equity markets. Debt investments also go through a downswing from time to time.
And if such a downswing were to happen during a period of widespread economic crisis, the drop in debt investments may also be sudden, severe and vertical (a sharp drop over a short period of time). Therefore the best that investors can expect from their debt investments in terms of risk management is to soften potential drops in the overall value of the portfolio, and not absolute protection against a drop in portfolio value.
Some investors may look for incremental returns from debt funds by investing in credit risk funds. These are a category of debt funds that invest mainly in bonds of companies that are of an inferior quality in terms of their inability to meet their interest payments on time (technically called credit risk).
These funds make up for the lack of portfolio quality by offering investors a higher potential return. But taking on the incremental risk it demands makes very little sense given that debt is an asset class that is meant to give stability to the portfolio. Also, if one of the bonds in the portfolio of a credit risk fund were to default, the NAV of the fund would likely drop sharply and the loss would likely be permanent. Credit risk funds must therefore be avoided at all costs.
On the other end of the risk spectrum within the debt fund universe lie gilt funds which enjoy a sovereign rating. This means that they are of the highest quality.
And because these funds invest in bonds issued by state and central governments, there is virtual certainty with regard to the timeliness of interest payments. But virtual certainty does not imply absolute certainty. There is the always possibility (albeit very remote) of a sovereign default, as witnessed most recently in Argentina in 2020.
Finally, it is important to pay attention to the average maturity period of the bonds in a debt mutual fund. The average maturity of a debt fund chosen for a particular goal should be significantly lower than the term of the goal the fund is chosen for. For example, a debt fund with an average maturity of 1 year should be chosen for a 5 year goal. Matching the average maturity of the fund to the term of the goal would be risky because individual bonds in the portfolio of the debt fund would have maturities that are much higher than the average. This would heighten volatility and increase portfolio risk.
Developing a well rounded understanding of debt mutual funds requires investors to realise and accept that such funds cannot offer returns with the kind of stability that a bank deposit does. They would carry the risks associated with any other market linked asset class and therefore can only be expected to manage risk and not provide absolute protection against it. And most importantly, the average maturities of the funds chosen for various goals must be significantly lower than the term of each of the goals. This would give investors an understanding of debt funds that is sound enough for them to be able to consider investing in them.