Do you really need debt in your portfolio?

By Larissa Fernand |  19-11-21 | 

In a recent interaction, Sankaran Naren, the CIO at ICICI Prudential Mutual Fund, advised investors to tread cautiously and suggested that they not ignore debt in this bull run. “You won’t lose money investing in a liquid fund or an overnight fund. Even in other debt funds such as floating rate, ultra-short term, medium term, and dynamic bond fund, the chances of losing money are slim. Debt is a capital protection tool, and not a return tool,” he said.

A reader wrote in with the comment that “Debt does not save capital, in fact, debt erodes capital”.

He is completely right when viewed in the context of inflation inching upwards but interest rates remaining low. Add to it the reality of rising life expectancies, which require a retirement portfolio to have a much longer life. All this contributes to the general consensus that people need to be holding more equity in their portfolios.

Muthukrishnan agrees that with returns being low, the hunt for yield makes one question the need for debt in a portfolio. “Still, it would be advisable to keep money in short term papers. Some portion of the wealth would be subject to some erosion. Real erosion due to inflation cannot be avoided. But having short-term debt would prevent nominal capital erosion,” he explains.

There is no denying the need for more growth assets, but it must be balanced with sufficient assets invested in fixed income to provide that buffer to the portfolio. Debt is NOT dispensable. Debt serves as risk-reducing ballast in a portfolio. That must be the focus when one is investing in debt, and its purpose does not change, irrespective of the state of the equity market or the low yields of fixed income instruments.

“The aim of an investor is not to always make big money, it is also to protect what you have. There are times in the market cycle when you invest to be cautious. The returns will be low or moderate, but capital protection takes dominance,” explained Naren.

Swarup Mohanty, the CEO at Mirae Asset Mutual Fund, too speaks of cycles: “The debt market, like equity, has its own investment cycle. When you invest with a medium to long term perspective, it has shown the ability to generate stable returns. In fact, sometime in 2019-20, the 10-year returns of G-Secs were higher than the Nifty.”

Please remember this:

  • Capital preservation and capital growth have to be viewed in conjunction. A portfolio must be constructed with both goal posts in mind.
  • During certain phases, one asset class may appear dispensable. Don’t fall for that narrative. In a rampant bull market, you may question why you are invested in debt. In a brutal bear market as we witnessed in the first half of 2020, you may want to flee equity altogether. Don’t act on your impulses.
  • The bedrock of a portfolio is suitable asset allocation. The asset classes must complement the other, not compete with them. To draw an analogy, the 64 black-and-white squares on a chessboard complement each other and give structure to the layout. Each occupies a different position and serves a purpose. A chess board must have both.
  • Depending on a host of factors, you will have to arrive at your own equity and debt allocation. You then work within that framework. Younger investors who have a long time horizon for their investments don't have a need for a big allocation to debt. But the closer you get to your goal date, especially retirement, the more you need to consider debt.
  • Debt serves the role of a shock absorber, and does help take the edge off in periods when equities are volatile.
  • Finally, remember that a portfolio is more than a collection of holdings. The key consideration when constructing a portfolio is how the holdings work together to help you reach your financial goals. This is far more important than the return of any single holding.

For perspective, let me close with an analogy between government debt and insurance by Dan Kemp, Global CIO of Morningstar Investment Management Europe.

In an environment of rising inflation, holding government debt is likely to act as a drag on returns. However, the same is true of most insurance. Insurance is a cost you pay to provide you with a return in the event of a particular outcome. When using government bonds as ‘portfolio insurance’, the outcome we are concerned about is a sharp fall in equity prices, a risk that is currently elevated due to the high price of many equity markets. The long-term studies we have conducted show that developed market government bonds provide the best protection during an equity market crash.

However, like all insurance, it will not protect your portfolio in all circumstances. In an environment of rising ‘real yields’ (the difference between the interest rates and inflation) both government bonds and equities are likely to deliver losses to investors, as witnessed during the ‘taper tantrum’ and the 1994 U.S. bond market crash. Investors need to consider the relative likelihood of that outcome versus the more typical negative correlation between equities and bonds when the price of the former is falling.

It is also important to consider the price of the insurance. Paying too much for insurance (owning government bonds that are significantly over priced relative to the risk in equity markets) could erode your capital and prevent you from reaching your goals.

Finally, we need to consider the enabling characteristics of insurance. If holding government bonds in portfolio enables us to take larger positions in deeply discounted assets with a long-term return that more than compensates for expected loss on the bonds, holding bonds would represent a good use of capital. Equally using bonds to insure a portfolio of over-valued securities is likely to deliver a negative outcome over the long term.

Add a Comment
Please login or register to post a comment.
ninan joseph
Nov 21 2021 05:54 PM
 During certain phases, one asset class may appear dispensable. Don’t fall for that narrative. In a rampant bull market, you may question why you are invested in debt. In a brutal bear market as we witnessed in the first half of 2020, you may want to flee equity altogether. Don’t act on your impulses

Fully agree with this statement. Debt is not dispensable. It should be a part and parcel of your portfolio construct. It is like the foundation on which you will build a house. You may not see the foundation day in and day out, but this is what holds the house.

The only difference of opinion is the type of debt. In my view, push as much money as you can in Post Office, and all kind of Government Schemes and then FD.

If you are opting for Corporate debt via MF, the risk as high because when the economy falters like in March 2020, companies will lose out too and they will not generate enough cash to pay on due dates unlike FD in a Bank. Even if the bank makes losses, the bank has to give back your money.

Hence if you invest in Corporate Debt, the risk is not hedged.
1<>
Top
Mutual Fund Tools
Ask Morningstar
Feedback