How advisers are navigating the debt funds space

By Ravi Samalad |  05-05-20 | 

The closure of Franklin Templeton Mutual Fund’s six debt schemes has caught everyone off-guard. The quest to earn higher returns drew investors towards credit risk funds. Now, investors are curious to know what they should be doing with their existing debt fund holdings. For new investors, choosing debt funds is a herculean task given the fact there are 16 categories on-shelf.

We asked three leading advisers how they pick debt funds, what role this category plays in the portfolio and the risks associated with them.

Here’s what they have to say.

Shortlisting debt funds

Within the shortlist of funds having lower credit risk, my preference is for funds that have a conservative approach towards managing their debt portfolios and have a predictable style and clear thought process. Some other factors are fund size, vintage, concentration risks within funds’ portfolio (to instruments and issuers), expense trends, etc.

Consult an adviser

Most debt funds investors are unaware of how to assess the risks. They are unable to distinguish between interest rate risk which is about returns being hampered versus the credit risk where the risk is about losing capital. So when it comes to debt, any day you should give more weightage to control credit risk for most investors and especially the risk-averse ones. And when it comes to debt funds, better to talk to an adviser if you are not sure about these. No point taking blind shots and praying for them to work.

Rehaul categorization norms

There is a separate category for credit risk funds. But there are still funds in other categories that carry enhanced ‘credit risks’ without it being reflected in the category name. How? They use workarounds around Securities and Exchange Board of India, or, SEBI’s, definition to expose themselves to high credit risks to generate additional returns. They then generate higher returns than their peers for a year or two in favourable market conditions. This attracts unsuspecting investors who don’t understand that the source of high returns is unwanted and high-risk behaviour of these funds that can backfire in unfavourable markets.

Investors pick debt funds basis category. That is in a way, the category is used as a proxy of the riskiness of funds. But many times, the actual risk is very different due to the fund’s choice of bonds/papers even within the definition of the category. Thus, SEBI needs to look into this aspect very seriously. If this demands one another round of category rationalization or definition tightening for debt funds, then so be it. Also, communication from fund houses and product labelling (to highlight marking the risk in different debt fund categories) should be overhauled so that it only attracts the right kind of investors.

Credit funds were mis-sold

Unfortunately, some fund houses and distributors had been positioning some of these credit risk funds as an alternative to fixed deposits. This was really unfair on their part and I feel sorry for small investors who were impacted by this behaviour. The regulator should seriously look into how to control the narrative for riskier products as clearly, product labelling or categorization weren’t enough. - Dev Ashish, Founder, Stable Investor.

Safety first

Around 80% of clients’ debt allocation should be in core portfolio i.e. Banking & PSU Debt Funds or Corporate Bond Funds that can beat fixed deposit return post tax over a 3 plus year time frame. The remaining 20% can go in duration/credit plays provided the client is comfortable or has asked for the same. In debt funds the objective should be SLR and in the same order: Safety, Liquidity and Returns.

If you want risk, go for equity

Investors would do well to avoid taking excessive risk in debt funds. If someone wants to take risk, equity is a much better option. Because in debt funds, the upside is limited, and downside can be the risk on entire capital. Further, debt markets can have contagion effect. One debt event can lead to crisis of confidence in the entire space.

Take tactical allocation

Credit risk funds are akin to small cap funds. Most investors don't need this kind of high risk /high return funds. Only in specific cases, if the client understands, then credit funds can be advised from a 3+ years perspective. It can form as a tactical part of the portfolio.  - Gajendra Kothari, MD & CEO, Etica Wealth Management.

Go for traditional debt products first

The first preference in debt products is for Provident Fund, Public Provident Fund, Voluntary Provident Fund, Sukanya Samridhi Yojana, etc. I suggest debt funds only if clients have more money to invest in debt funds beyond these products as per the asset allocation. In such cases, I recommend only liquid fund & ultra short-term debt funds.

Choosing a fund house

I avoid fund houses which take risky call for extra return. I personally believe that we can take risk in equity, not in debt. I prefer a bit conservative fund houses which are process driven and invest in high rated securities.  Funds with decent assets can reduce the risk further.

Credit risk funds are not for retail investors

I was aware of the risk in credit risk funds and that it could be impacted more in an extreme situation like COVID19. Now, I am becoming bit more conservative in the debt space, even at the cost of return. Return of capital is more important than return on capital now.

I never suggest credit risk funds to retail investors.  It is meant for evolved investors who invest in it with full knowledge of the risk attached.  Such investors invest a small portion of their debt portfolio in credit risk funds.

Where to invest

Retail investors who don’t want to take higher risk for higher return should stick to these three types of debt funds only – Overnight funds, liquid funds and ultra-short term debt funds.

If investors have debt mutual funds in their portfolio, they should check the percentage of investments in funds other than overnight funds, liquid and ultra-short term debt funds.

Diversify

Even if you are 100% sure that the composition of portfolio is right and the fund house is good, diversify it across fund companies. Don’t go overboard on investing in different funds of one single AMC.

If you have an investment horizon of less than three years, move the amount from debt funds to fixed deposits. We still do not know how this Corona virus will impact different industries. Debt funds are meant for tax efficiency; not returns. Though you will have to pay an additional amount of tax if you move to FDs from debt mutual funds, it is better to play safe than sorry.

Non-Resident Investors

There is no need for NRI investors to invest in debt funds. For them, fixed deposit and recurring deposit from Non-Resident Rupee, or NRE, account is better than debt funds, because the interest from those is tax-free in India. - Melvin Joseph, Founder, Finvin Financial Planners.

Share with us your views on how you are navigating the debt funds space.

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