Debt funds are now under the spotlight, especially over the past couple of months. Especially since Franklin Templeton froze six of its debt funds with INR 28,000 crores in assets, and net monthly flows in debt MFs doubled from INR 43,431 crores in April to INR 94,224 crores in May; debt funds have been in the news for all sorts of reasons.
The mystery that surrounds debt funds keeps on growing. But with a sound understanding of debt funds, and the right rationale for choosing a debt fund; investors can now add another asset class to their portfolio.
Understand the risks involved
The default risk
Debt is very peculiar as an instrument. The borrower is obligated to pay the investor a fixed interest payment at fixed intervals, and then return the principal upon the maturity of the debt. The problem here is that not all borrowers are creditworthy. Thus, there is always this risk that a borrower might simply miss payments, or worse still, not even make them at all. This is known as the default risk. This is where rating agencies play an important role. Agencies like Crisil, Fitch, ICRA, assign ratings to these debt instruments.
The interest rate risk
Even when the borrower meets the scheduled obligations, the investor might end up with less than what had been settled for. For instance, an investor might have issued debt at a rate of 10%. However, borrowers of similar creditworthiness are now paying 12% for that same amount of money. However, the investor can now not demand the extra 2 percent from the existing borrower. All future payments from the borrower will go down in terms of value, which will ultimately pull down the overall value of the debt. This is the interest rate risk.
Longer debt tenures will have more chances of interest rates moving against the investor. Also, long term debt securities have higher interest rates than shorter ones.
One way to reduce this risk is to invest in a portfolio of debt securities or debt mutual funds. Debt funds tend to invest in multiple debt instruments, all of which mature at different times. These have also been structured to provide the investor with diversification benefits. Both interest rate risk and default risk are still present; it is merely the price sensitivity of the fund to the risk that is different.
Choosing the right fund
Considering all the uncertainty that surrounds the pandemic, it is important to ascertain which debt fund is a rational choice. Assuming that the goal of the investor here is to maximize returns while also preserving capital; the final choice would depend on the macroeconomic outlook of economic activity, and interest rates.
Economic activity has come to a standstill ever since the lockdown happened. In both rural and urban areas, demand has collapsed. Even electricity consumption, which has strong correlations with the GDP growth, has plunged. Service sector areas, like air traffic, foreign tourist arrivals, passenger and commercial vehicle sales; all of these have been hampered too!
As per a survey of 300 companies conducted by the CII that was released on 2 May 2020, 65% of the surveyed companies expect that their revenues will contract by 40% in June. Naturally, with declining revenues, a company is also unable to meet its payback obligations. Investors need to understand that the default risk that is associated with less than investment-grade bonds is now at its peak. Funds that invest primarily in highly rated debt instruments are better poised to sail through this storm.
The RBI is under pressure to keep the interest rates low in the short term to spur economic activity. RBI has further reduced the policy repo rate by 40 bps from an already recorded low of 4.4%. However, upward pressure on interest rates will be created in the long term, because of increased government borrowing, FPI outflows, and inflation. Long term interest rate movement is now more uncertain than it ever has been.
Putting two and two together, it is easy to understand that a fund that has concentrated holdings in high-grade debt and shorted durations is a more sensible choice, such as money market funds or liquid funds. Funds with large AUM will allow the fund manager to maintain liquidity, even during periods of premature and large redemptions.
Choosing a debt fund appropriately can preserve not just the capital, but also offer you modest post-tax returns. However, as an investor, do not overestimate the safety of debt funds. Similar to other market-linked instruments, these carry an inherent risk. A portfolio that is diverse and well-structured, with different asset classes such as cash, bank deposits, real estate, stocks, debt, etc. is much more resilient when it comes to absorbing shocks when compared to concentrated investments.