Important Debt Mutual Fund Considerations For Investors

Debt Mutual Funds have been in the news for all the wrong reasons of late! We’ve seen multiple credit events spooking the fixed income market, starting with the IL&FS fiasco that unravelled last year, to the more recent DHFL related write downs that resulted in a precipitous drop in NAV’s for many mutual funds that were unfortunate enough to be holding their paper on the write down date. And yet, it rings true that a good number of well managed debt funds have been consistently spinning out 8.5-9.5% annualised returns during this entire tumult. While the more risk averse are migrating back to the haven of FD’s in hordes, many investors continue to have faith in debt funds, and for good reason. Over a medium-term timeframe, they have the potential to deliver tax adjusted spreads of 250-300 basis points over FD rates. If you’re planning to stick around in debt funds, here are a few important considerations for you.

Understand the Risks

While equities are fairly simple to comprehend, debt markets are far more complex. Multiple risks exist within the category. For instance, in the event that the reserve bank starts tightening liquidity by raising rates or selling bonds in an effort to curtail inflation, we see bond prices and debt fund NAV’s falling. Longer duration bonds such as government securities (widely and wrongly perceived to be risk-free) take the biggest hit. Similarly, corporate bonds carry credit risk. It’s very difficult for lay investors to actually assess the creditworthiness of a corporate borrower by trawling through their balance sheets and cash flow tables, and credit rating agencies do precious little as most of them change ratings after credit events take place (akin to bolting the door after the horse has fled)! The support of a well-informed, expert Financial Advisor is crucial in selecting which debt fund to be in at what time; or else you could very well end up underperforming fixed deposits even after factoring in the additional tax efficiency.

Diversify

When it comes to Debt Funds, follow the age-old rule of diversification. It’s strongly recommended to not have more than 20% of your overall portfolio exposed to a single debt fund. Even within your portfolio, it would be smart to diversify across multiple categories, based on sound research and a solid tactical plan. For instance, you could hold low duration, medium duration, corporate bond funds and credit risk funds at the moment. Considering that yields have already fallen very sharply, do not be tempted to invest into longer duration funds such as GILT funds simply because they have spiked recently. There’s a third layer of diversification you should be considering – namely, “intra fund” diversification. Avoid debt funds that have large exposures to single securities. Go for funds that invest across 75-100 securities, as they would have a very low probability of being hit hard by a single unpredictable credit event. 

Remember – they’re not FD’s

In the end, remember that debt funds are not fixed deposits, so set your expectations accordingly. They will not fetch linear returns or pay you a predictable “interest”. However, they will likely net you far higher tax adjusted returns over a 3-year period, if they are well selected and patiently held on to. If you’re neatly diversified and smartly advised, debt funds make a lot of sense. Beware of going it alone or concentrating your holdings into a single fund, though.