Mutual Funds: Before You Invest

Stung by plummeting deposit rates, high net-worth individuals (HNI) and retail investors alike have been flocking to debt mutual funds in droves of late. With most bank deposits now offering no more than 6.5 per cent to 6.75 per cent per annum across popular maturities, low risk-taking investors have been, perforce, constrained to look for viable alternatives.

This fact is evidenced by the latest official numbers published by the Association of Mutual Funds in India (AMFI) that show that the share of HNI and retail investments in debt funds grew by 1.78 lakh crore (1.78 trillion) compared to the previous financial year, representing a significant 31 per cent jump.

The rosy numbers notwithstanding, there’s a disturbing undercurrent of ignorance at play with respect to debt mutual funds which, despite their burgeoning popularity, remain one of the most misunderstood — and misrepresented — investment avenues today. Unlike equity-oriented funds, which (despite their exponentially higher risk) are easier to understand, debt funds possess risks that are often not clearly understood by clients and their advisors alike.

Risks and Returns of Debt Funds
Debt funds generate returns from two sources. The first, which is simpler to understand, is by accruing coupon pay outs on a periodic basis from their underlying securities. The second, which is more complex, is by way of generating ‘capital gains’ on the same securities. To that effect, the total returns earned by a debt fund in a given period can be represented as “accruals plus capital gains”.

Intuitively, it follows that coupon pay outs are exposed to the risk of the borrower defaulting, or credit risk. “Credit risk relates to the ability of an issuer to pay the interest and principal during the life of a particular bond. If the issuer is not able to service the interest or principal, it can lead to loss of capital; this scenario is called credit default,” says Avinash Jain who heads fixed income at Canara Robeco Mutual Fund.

It rings true that there are no ‘free lunches’ in the investment world, and debt fund investors rubbing their hands in glee at their funds possessing higher yields-to-maturity, must also bear in mind that this potential excess return comes at the cost of increased risk. “Investors should be aware that if a debt fund is giving a higher yield vis-à-vis other similar products, it is likely to carry a higher credit risk, and hence, lower safety,” warns Jain.

In pursuit of capital gains, the fund manager primarily employs two strategies. The first one involves benefitting from falling interest rates by holding higher maturity bonds, whose prices fluctuate more sharply in inverse correlation with rate changes. “Interest rate risk is higher for funds with higher average maturities. Hence, the risk is lowest for liquid funds, and rises as the average maturity of the fund increases,” points out Jain.

Alternatively, fund managers can elect to take on a deliberate credit risk by buying lower rated bonds, in the well-researched hope that they will undergo a positive ratings transition in the times to come. If the bet pays off, their yields would fall, resulting in capital gains.

The poor understanding that retail investors (defined by AMFI as those who have invested less than Rs 5 lakh in mutual funds) have of debt funds is underscored by the 54 per cent spike in GILT fund ownership this year compared to previous financial year. GILT funds are widely misperceived as risk-free as they invest in government-backed securities. But they are extremely sensitive to interest rate changes owing to their high average maturities. According to mutual fund research house Value Research, GILT funds have a category average maturity of 10.97 years as on date, implying that they will likely underperform debt funds with lower maturity portfolios and higher yields, if benchmark yields remain range bound in the near term — a highly likely scenario. In fact, retail investors may balk at the fact that there have been years in which the net asset values (NAV) of these purportedly risk-free GILT funds have fallen more than
15 per cent!

Similarly, investors need to exercise caution while deploying their money in credit opportunity funds that aim to generate alpha by taking on incremental credit risk and investing in lower rated instruments. “One needs to carefully weigh his/ her risk appetite for aggressive credit portfolios. A single credit default may have a large impact on returns. Therefore, the credit evaluation and the monitoring process must play a key role in fund selection,” explains Mahendra Jajoo, head of fixed income at Mirae Asset Global Investments.

Even liquid funds, commonly perceived as 100 per cent risk free by many individual investors, carry within their portfolios the risk of default. “Generally speaking, a liquid fund with a high-quality credit portfolio is very safe in terms of capital safety. In the unfortunate situation of a credit default though, implications could be serious,” explains Jajoo. A recent case in point is the shock faced by investors in Taurus Liquid Fund. They were hit hard by the downgrade of BILT papers that the fund was holding at the time. The impact of the fairly recent Amtek and JSPL downgrades on the debt portfolios of some large asset management companies has also been well chronicled.

What Is The Best Type Of Debt Fund Right Now
The key question that hangs in the air is — where should debt fund investors park their monies right now? Should investors veer towards high-duration portfolios, or focus more on accrual-oriented funds? Is the risk of investing into corporate bond funds with lower credit-rating portfolios still worth the potential reward? With their seemingly endless number of variants and sometimes baffling nomenclatures, picking the best debt fund to invest in can quickly turn into an ordeal.
Manish Banthia, senior fund manager of ICICI Prudential AMC, continues to hold a moderately bullish view on yields. “There is a limited threat to persisting low inflation. Therefore, our opinion is that RBI has set the stage wherein there is scope for a rate cut over the next two to three policy meetings,” he says. He further adds that “bonds in the 3-5-year maturity range could offer potential for capital appreciation going forward”.

Jajoo’s views seem to match Banthia’s, although he is less certain on the medium-term interest rate trajectory. He advises clients to consider corporate bond funds with accrual orientation and with high-credit quality at the moment. “Within this category, funds with a concentration in the 3-5-year maturity bucket should be rewarding in the medium term. At present, it seems that a moderate-duration positioning is better,” he advises.

Jain’s more general advice to investors is to diversify their debt investment portfolios by “following an asset allocation strategy across various debt fund classes”.

Pointers For First Time Debt Fund Investors
If, like many others, you are planning to migrate from the safe haven of fixed deposits to debt mutual funds this year, you might want to start off by investing into relatively lower risk, short-term debt or ultra-short-term debt funds with high-credit rating portfolios at first; even at the cost of potentially lower returns. Over time, you could gradually build a more inclusive portfolio comprising  funds with lower credit profiles or higher durations that have the potential to deliver 100-200 basis points higher annualised returns than their shorter-term, highly-rated counterparts.

Whatever you decide, it is imperative that you educate yourself on the nuances of debt fund investing before you jump in with both feet.