What debt funds are NOT

By Morningstar |  15-05-20 | 
 

Registered Investment Adviser DEV ASHISH clears the air about debt mutual funds by laying to rest four common misconceptions.

Debt funds are NOT substitutes of fixed deposits.

If you are an ultra-conservative saver who really doesn’t want to take any risks, steer clear of debt funds. Stick with bank fixed deposits. The assurance you get from it will not be available with a market-linked product.

Of course, a new risk that you would face is the existential risk to the bank itself. But if you stick with the systematically important and too-big-to-fail larger banks, you are on solid ground.

If you are not ultra conservative, then debt funds must not be ignored from a portfolio standpoint.

Having said that, don’t fall for false narratives such as ‘debt funds are like FDs’ and ‘debt funds are risk-free.’ These are grossly incorrect and misleading. No market linked investment, be it debt or equity, is ever risk free.

The focus of debt funds should NOT be return on capital.

When it comes to debt funds, I prioritize return OF capital over return ON capital. Because debt funds are primarily for capital preservation. To add alpha to my portfolio and beat inflation, I prefer the more volatile asset class – equity.

So why debt funds at all? Because the return is higher than that of a fixed deposit. The interest earned on a fixed deposit is added to your income and taxed in the income bracket that you fall under. Post the taxation, the return does not even beat inflation.

If a fixed deposit returns 8-9% post-tax returns, who would want a debt fund with its risks? But reality is that bank deposits return much less, and when you take into account inflation and tax, it is even more dismal. This is where debt funds comes into the picture.

At the cost of sounding repetitive, I once again reiterate: Opt for debt funds over fixed deposits because of the higher overall return, but don’t focus on optimizing returns to the point of ignoring risks. Capital protection must get your disproportionate attention.

Credit risks are completely avoidable over the short and medium term. It won’t change portfolio returns dramatically on the upside but the risk taken will increase manifold.

As for long-term goals, the credit risk should be capped to a small exposure as it can backfire at precisely the wrong times with no scope or time for recovery or course correction. And you wouldn’t want that kind of risk with your long-term goals.

So even though all debt funds have different degrees of interest risk and credit risk, I give disproportionately high weightage to limit the credit risk.

In fact, for ultra long-term goals like retirement, exhaust all safer alternatives such as the Employees Provident Fund (EPF), Public Provident Fund (PPF) and Voluntary Provident Fund (VPF). Only then should the entry of debt funds into your portfolio follow.

Besides the slightly higher return than fixed deposits, an advantage of debt funds is that they provide an easier and more liquid route to rebalance the portfolio in both directions.

Debt funds are NOT about return maximization.

To maximize returns, you need to take risks. And if you need to take risks, do it via the equity component in your portfolio. Not debt.

Most investors want high returns irrespective of the asset they are investing in. When you see a fund delivering that extra return, check whether it is coming from additional credit risks embedded in the portfolio.

Within the shortlist of funds having low credit risk, preference should be for funds that have a conservative approach towards managing their debt portfolios and have a predictable style and clear thought process. Some other factors that should be considered are AUM of the fund (avoid very small ones), vintage (avoid unproven new ones), concentration risks within funds’ portfolio (to instruments as well as issuers or groups), expense trends, etc.

Don’t get blindsided by star fund managers. You never know when the underlying risks will jump up and punch you and the fund manager in the face.

Most investors are unaware of how to assess the risks in debt funds. They are just unable to distinguish between interest rate risk (which is about returns being hampered) versus the credit risk (where the risk is about losing capital). Give a lot more weightage to controlling the credit risk, especially if you are a risk-averse investor.

At this juncture, it is only fair that I talk about credit risk funds.

I have never understood the reason to take high risk in debt. And credit funds are built on the high-risk premise itself. So credit risk funds, as a category, has always been a clear avoid for me.

While there is a separate category for credit risk funds, there are funds in other debt categories that carry enhanced ‘credit risks’ without it being reflected in the category name. The fund managers deliberately expose themselves to high credit risks to generate additional returns. This is why it is foolish, and dangerous, to pick debt funds based on the chart toppers. The source of high returns is probably unwanted and high-risk behaviour of the respective fund managers, and it can miserably backfire in unfavorable markets.

High returns mask the risk being taken.

So if a debt fund is delivering really high returns compared to its peers, it must be taking a risk that is playing out well for now. Whether it will continue to play out well going ahead is anyone’s guess.

What is the source of their out-performance? Ask yourself that question. Always.

All debt funds are NOT the same.

Another lesson that should be learned is that all debt funds are not the same. There are different debt fund categories. And even within  a category, do not assume there is homogeneity. Open the bonnet of these funds and you will see that their engines have several unwanted components; hidden from investors who don’t bother to look.

Actual risk can be very different from perceived risk. Investors pick debt funds based on the categories. 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.

Even though the category of a debt fund may be an indication of the average maturity profile of the fund, the actual bonds/papers held by the fund may be of a longer duration. So an ultra-short duration category will have 3-6 months average maturity profile. But it may hold bonds/papers that have a maturity of 1-2 years as well.

Why?

Because the category rule is about the average maturity and doesn’t mean each and every component needs to have this maturity limit. Only the portfolio average should be within the definition. So the average maturity can be really deceptive as there’s a big gap between actual maturity/liquidity and what it seems to be at the category level.

On a closing note…

I do hope this helps you make smarter decisions. But if you are unable to evaluate debt funds from all the vantage points discussed above, it would be wise to take professional advice. Avoid random picks based solely on past performance or guesswork.

Also read How to build a debt portfolio.

Investment Involves Risk of Loss

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