Know the Underlying the Risks in Debt Mutual Fund Schemes

Many investors would be cheering those who had already invested in debt mutual fund schemes over the past year. They would have earned good returns thanks to frequently rate cuts by the Reserve Bank of India (RBI) over the past year. Many still expect interest rates to continue to move downward, over the next fiscal year. But, recently the RBI has kept their rates unchanged, broadly in line with market expectations. Over the past year, debt schemes have benefited from declining interest rates, much before the repo rate was actually cut by RBI. Many conservative and gullible investors are getting lured their high safe returns generated by various debt schemes. They are falling the pray to pour their money into debt funds supposed to be safe without understanding the underlying risk in debt schemes like in equity schemes. Though debt funds do not invest in equity, they only invest in debt instruments issued by the government, banks, and corporate entities, thereby having four type of risks are inherited by an debt MF’s portfolio in the form of interest rate cycle, credit of the underlying investments, Investment by FIIs and average duration of scheme’s portfolio, which is less known by a layman investor. Unfortunately, while picking debt schemes, most investors focus on only past high returns and prone to think past returns are secured. They do not recognize the fact while investing in debt scheme offering high returns is at a high risk, hence they could see value erosion in unfavourable circumstances. It is because very difficult to explain capital loss in a debt fund to the lay investor while losses in equity MFs are more easily explained as it is blowing in the mirror of Sensex and Nifty Index.  But in debt mutual fund schemes’ performance and risk are undertone into the money market.

Debt mutual fund schemes have a wide variety of schemes such as: liquid, ultra-short, short-term, medium-term, income, and gilt funds. Every scheme has set own benchmark for their returns and various risks are involved which may affect the returns of debt schemes. Therefore, before investing in debt scheme, investors need to understand the basic concept of all categories of debt schemes so that she can enable to invest, according to her investment objectives and horizon.

Liquid Funds and Ultra short term Funds

Liquid funds are generally considered less risky as compared with ultra ST funds on account of the fund duration being lower. Moreover, there is no mark-to-market requirement in liquid funds and NAV valuation is done on accrual basis by adding the coupon accrued for the day. That’s why liquid funds are never given negative return over the three decades. For ultra ST funds, the portions of securities with a maturity above 90 days have to be marked to market. In other words, the change in their market price as a result of change in yield has to be recorded on a daily basis, which may cause additional volatility in NAVs. Generally, the marked-to-market portion of the portfolio in ultra ST funds is not high, thereby minimizing the impact of price change. Given that funds in both these categories are giving around 7.5-9.5% p.a. and are considered relatively less risky owing to the short maturity of the securities held by them, they are good to build up a contingency fund (typically 3-6 months of investor’s expenses). They are typically compared with saving bank account which can able to generate more returns than saving bank rate. Moreover, liquid funds or ultra ST also help to set-aside your surplus balances from your bank, so that you can avoid impulsive spends from your debit card and could use the funds, only in case of emergencies.  Liquids funds usually don’t have an exit load. Ultra ST Funds may charge exit load in the range of 0.1-1% if funds are redeemed before a specified time period, in the range of one week to six months. The exit load helps ultra ST funds maintain stability and manage fund outflows better. This is beneficial for small investors and reduces NAV volatility.

Income Vs Short-term Fund

Income funds tend to invest in longer-tenure instruments like government securities and corporate bonds, and their average maturity lies in higher band of 5 to 8 years. Whereas short-term funds confine their portfolios to short-term instruments like commercial papers, short-term bonds and money market instruments. Thus their average maturity largely remains in the 1-2 years range. This relatively higher maturity of income funds makes them more susceptible to interest rate risk, thus making them more volatile. However, this volatility gets nullified over a longer period of time. Short-term debt funds and income funds are meant to cater to investors with a different time horizon. Income funds are for the long-term investment of at least a year or so, while short-term debt funds are suitable investment avenues for periods less than that. In the past one-year, an average income fund has delivered a return of 10.50 per cent, whereas short-term debt funds gave 9.50 per cent return as on July 31, 2016.

Gilt Funds

Gilt funds invest exclusively in debt securities issued by the central and state governments in India. Gilt funds consist of government issued debt securities whose duration can go up to 10-15 years. Hence, among debt investments, these are considered the most risky. Even a slight fall in interest rates will make the current holdings worth more, thus increasing the net asset value (NAV) of the fund. Conversely, a slight increase in interest rates will make the NAV go down significantly as well. The longer the duration of a portfolio, the higher the risk that it incurs. This is so since the movements in interest rates have an amplified impact on the funds that have long duration portfolios. The typical understanding about debt funds being much safer than equity funds applies less to this category as they could see capital erosion in adverse interest scenario. Technically, these are driven by periodically review of monetary policy announced by RBI. Of course, under favourable conditions, these funds could also yield better returns than a regular debt fund. In this way, these can be compared with sector funds in the equity space. Just as sector funds, gilt funds are focused in their investments, and have consequent risks. From an investor’s point of view as well, they should get into such a fund only if they are knowledgeable and can figure out when to book profits and get out of the fund. At present, it is prone to believe that interest rates are getting downward trend; and this means that it is a good time to get into gilt funds. If you can figure out the time to exit these funds in a similar manner, you can invest in them. Else, it would be safer to stay with “diversified” debt funds such as income funds, or short-term funds, wherein the risks are lower.

Credit Opportunities Fund

In a credit opportunity fund, the fund manger invests in low credit rated funds like less than “AA” rated. Lower the credit rate leads to higher the return. However, ratings should not only be looked as core factor but also at the health of a company. Downgrades and upgrades are a regular feature of these funds and a downgrade should not be confused with a default. The one-year category average return of credit opportunity funds is currently the highest among all mutual fund categories at 9.20 per cent (maximum 10.70 per cent and minimum 7.74 per cent), according to the mutual fund rating agency Value Research. This has no doubt been aided by the fact that interest rates have declined significantly over the past year, so duration-oriented funds have outperformed. Before investors rush out to invest in credit opportunity funds for their returns, they should understand how these funds work and the risks they carry.

Dynamic Bond Fund

Dynamic bond funds invest purely in fixed income instruments, such as corporate bonds and government securities.  However, they differ from traditional income funds in that the fund manager has the flexibility to actively manage the duration of the portfolio, depending on his view of interest rates.  It is designed to give the fund manager the flexibility to change the duration of the bond as and when needed. In fact, funds believe that they should have bond funds where fund managers have more flexibility in a changing interest rate climate. Interest rates and bond prices are inversely related. When the interest rate is rising, bond prices fall and the fund manager should be able to decrease the duration of the bond; short-term bonds face a lower impact. And when the interest rate is falling they should be able to increase the duration of the bond. When you invest in the dynamic bond funds, you are taking a call on the future interest rate movement. This involves an element of market timing, something lay investors are not in a position to do on their own. So dynamic bond funds are ideal for those investors who want to put their money in debt funds but do not want to time the market. The onus, here, would lie with the fund manager, who has the expertise to deal with interest rate volatility.

Taxation Treatment

Like bank’s FD return, all the gains of debt funds are subject to taxable as per your income-tax bracket if it is held for a period less than three years as it would be considered as short-term gain but it is not taxed on your accrual gain like bank FD’s interest. If you do not wish to withdraw the funds from any debt scheme within three years, it is treated as long-term capital gain and be taxed at 20% on inflation adjusted return, its net effective tax rate may much lower than, even 10% of your gain. Debt schemes also scores over bank FD in term of any losses are incurred on debt schemes will be adjusted or carry forward against any future gains of other debt income, as the case may be. In nutshell, debt mutual fund schemes are more tax efficient than banks FDs. Moreover, if you are a resident Indian, there will also be no tax deduction at source (TDS) on the gains of schemes.

Your Debt-Income Choices

To understand whether or not you should invest in debt schemes, it will depend on your investment objectives, time horizon and your asset allocation approach. While interest rate risk is inherited in any debt security, one must be also careful on the credit quality. Given the large number of debt MFs, it would help the investor also checks on the underlying investments of the scheme shortlisted by them or their investment advisers. Thus, opting for debt MFs can be a good option for investors based on their interest rate views, investment horizon, and risk appetite, especially in a declining interest rate scenario. Ideally, they can hedge against downtrend in equity funds and should be part of your asset allocation to give the balance of one’s portfolio. While selecting debt funds, investor should be selective among the debt schemes as the interest rates could be headed at either side, could backfire badly.

PS: This article got published in Hindi Dainik Bhaskar on 13-12-2016

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