/Are debt funds still a credible choice for investors?

Are debt funds still a credible choice for investors?

By Suresh Sadagopan

The going has been tough for debt mutual funds since the IL&FS debacle in mid 2018. This triggered a crisis of confidence and it affected NBFCs and Housing Finance Companies (HFC) in the financial sector. Banks were reeling under the NPA problem already and they had virtually stopped lending to NBFC/ HFC and real estate sector as also to many other businesses with higher risk like MSMEs and other corporates which had cash flow problems/ mismatches.

Financial entities and businesses were facing problems while trying to raise loans/ capital and their cash flow problems which impacted their ability to pay back past loans.

Such tightening, cashflow problems of the businesses and other issues caused some defaults like it happened with DHFL, Vodafone, Zee Group etc. Many other names have cropped up due to the subdued economic situation, the caution of the banks in view of their high NPAs and the stress they themselves were going through and the problems. This affected retail and institutional investors alike and risk aversion started manifesting.

The situation hence was difficult at the start of 2020. Then the corona crisis struck and all hell broke loose. A tough situation got worse as a lockdown was announced and the ability of companies to continue their business was hit badly. On top of that a moratorium was announced, which meant that borrowers need not pay the monthly instalments for some time and can defer it.

All this produced panic in the debt markets and many papers turned illiquid. So the exit path was closed for those holding those illiquid papers. And Franklin Templeton had to shutter six of their schemes due to this.

There has been a lot of coverage ( mostly adverse ) on debt MFs in the past two years. In this piece, I would like to examine if debt mutual funds are still a good option for investors to consider.

About Debt MFs
Let us first look at the fundamental premise. Debt MF schemes of various hues invest across durations, credit ratings and ownership profiles. In that sense, Debt MFs taken as a whole, represent the entire debt markets. What happens in the debt markets are bound to impact Debt MFs as well.

If there is a liquidity crisis or a credit event, it will impact the debt market as well as Debt MFs, which is a participant in the debt markets. However, depending on which segment of the debt market or which paper gets affected, a set of schemes exposed to that segment/ papers will be impacted.

In such unusual times, debt market turbulence can be expected even going forward. That needs to be managed well.

Advantages of Debt MFs
Debt MFs are great vehicles to manage that. Let us examine the advantages that they offer.

Fund Manager oversight
A fund manager and his team is always managing the fund as per its mandate and closely monitoring the underlying investments. They are well qualified and are retained to oversee investments on an ongoing basis. They are experts who take necessary actions in the schemes they manage. This ensures that the underlying investments are good as they take appropriate & timely actions in the schemes under their watch.

Debt fund schemes typically have between 10 to 40 underlying papers, which are chosen as per the fund mandate. Hence, one gets advantage of such excellent diversification even if the amount invested is small. Even in the event of a default or any other trouble, the exposure is a miniscule percentage, to the extent of the holding in those papers only. This is in stark contrast to a direct hit an investor would suffer, if one is holding the exposed paper.

Funds across the spectrum
Debt funds straddle the entire spectrum of duration, credit play, different management strategies, sectors and themes etc. There are funds for investors who want to invest for the very short-term like overnight funds, liquid funds; there are medium and long-term funds; there are credit risk funds, dynamic bond and corporate bond funds; there are gilt funds, banking & PSU debt funds etc. Hence, an investor can precisely zero in on what s/he wants and invest in the precise category & fund they want to.

Many debt instruments may not be liquid by its very nature. However, they can be sold in secondary markets. But liquidity may not always be there. However, if one goes through the MF route, the investment is totally liquid. There could be a time period in which there can be an exit load. Beyond that it can be redeemed freely without any penalty.

Price discovery
The NAV is published in the case of debt MF, on a daily basis. Hence, one would know what the value of the investment one has done in a debt MF, at every point. When one cashes out, it will be redeemed on the day’s NAV and one would get the money in a couple of days.

Price discovery may be difficult for papers held directly by retail investors as some of these papers don’t trade much.

Gains in debt MFs are subject to capital gains treatment, as against the income treatment for most other debt papers.

For investments held for a period of up to 36 months, short-term capital gains treatment would apply, where the gains would be added to one’s income. For investments held beyond 36 months and sold, Long Term Capital gains treatment will apply. This leads to better tax adjusted returns, especially when it is beyond a thirty six months holding period.

Some of the papers are available in quantities which a retail investor will not be able to invest like multiple of ten lakh rupees or more. Debt MFs help retail investors participate in opportunities that are otherwise out of bounds for them.

Non availability to retail investors
Some papers are placed privately and are not available at a retail level at all. The interest rate also will be higher than what typically a retail investor may get. Again, a Mutual Fund would be able to buy these and a retail investor would be able to participate in these opportunities.

Income setup
Income can be set up from a debt MF through Systematic withdrawal. The withdrawal in a year needs to be less than what the fund would generate, to be able to sustain. This allows a person to set up the amount of income they need, in the frequency they need. This can be stopped, varied, restarted, withdrawn in a lumpsum manner etc.

In the case of many debt instruments, either one has no flexibility in setting up the income they need, or cumulative and regular income cannot be set up at all.

The allure of debt MFs has no way dimmed due to the recent happenings. They continue to be one of the best options in the hands of the retail investors. However, one should select the sub-categories and funds with caution as per the needs, invest in them & monitor them. If this is difficult, one should seek professional help.

(Suresh Sadagopan is the founder of Ladder7 Financial Advisories, a financial planning firm based in Mumbai.)

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