/Do debt funds still have a place in an investor’s portfolio?

Do debt funds still have a place in an investor’s portfolio?

Dr Neelam Rani

Debt funds are under the spotlight. Over the past couple of months, this relatively obscure sibling of equity funds has been in the news for all kinds of reasons: from Franklin Templeton freezing six of its debt funds with Rs 28,000 crore in assets to net monthly flows in debt mutual funds more than doubling from Rs 43,431 crore in April to Rs 94,224 crore in May. The mystery around debt funds for an average investor just keeps growing.

However, with a sound understanding and the right rationale for choosing a debt fund, investors can add another asset class to their portfolio.

Understanding the risks
Debt, as an instrument, is peculiar. The issuer (borrower) is contractually obligated to pay the investor (lender) fixed interest payments (coupons) at fixed intervals and return the principal at the debt’s maturity. But not all borrowers are equally creditworthy. So, the risk that a borrower may miss payments, or even worse, not make them at all is ever present. This is called default risk. Ratings agencies like Crisil, Fitch, ICRA, etc. assign ratings to debt instruments.

But even when the borrower is meeting his scheduled obligations, the investor could end up with less than what she bargained for. For instance, the investor may have issued debt at the rate of 10%, but now borrowers of similar creditworthiness are willing to pay 12% for her money. However, the investor cannot demand the extra 2% from her existing borrower. In fact, the value of future payments from the borrower will effectively go down, pulling down the overall value of the debt. This is called interest rate risk.

Obviously, the longer the debt tenure, the more chances are of interest rates moving against the investor. Longer-term debt securities have more interest rate risk than the shorter ones.

One way of reducing the risk is to invest in a portfolio of debt securities or a debt mutual fund. Debt funds invest in multiple debt instruments which mature at different times. They are structured to provide the investor with diversification benefits. Notice that both interest rate risk and default risk will still be present; it’s just the fund’s price sensitivity to the risks which would be different (ideally less).

Choosing the right fund
But given the increased uncertainty arising from the pandemic, what kind of debt fund would be a rational choice? Assuming the investor’s goal is to maximize returns while preserving capital, the answer would depend on the macroeconomic outlook of economic activity and interest rates.

Economic activity has been all but crippled by the lockdown. Demand collapsed in both rural and urban areas. Electricity consumption, which historically exhibits strong correlation with GDP growth, has plunged. In March alone, service sector activities such as passenger and commercial vehicle sales, domestic air traffic and foreign tourist arrivals plummeted.

A survey of 300 Indian companies, released on 2nd May by Confederation of Indian Industries (CII), suggests that 65% of the surveyed companies are expecting revenues in June to contract by 40%. Declining revenue severely impacts a company’s ability to meet payback obligations. An investor should understand that the default risk associated with less-than-investment-grade bonds is now highly magnified. Funds investing primarily in highly-rated debt instruments would be better poised to weather this storm.

Of course, to spur economic activity, RBI would be pressured to keep the interest rates low in the short term. Post the emergency Monetary Policy Committee meeting in May, RBI further reduced the policy repo rate by 40 bps from an already record low of 4.4%. But in the long-term increased government borrowings, inflation and FPI outflows will create upward pressure on interest rates. Long-term interest rate movement is more uncertain than ever.

Now if you put two and two together, you’ll realize that a fund with concentrated holdings in high-grade debt and short duration seems like a sensible choice, such as liquid funds or money market funds. Funds with large Assets Under Management (AUM) will allow the fund manager to maintain liquidity during an incident of premature and large redemptions.

The right choice of debt fund can preserve your capital and offer modest post-tax returns. However, an investor should not overestimate the safety of debt funds. Just like any market-linked instrument, they carry the risk inherent in the system. A well-structured diversified portfolio of different asset classes (cash, stocks, debt, bank deposits, real estate, etc.) will be more resilient to shocks than siloed and concentrated investments.

Dr Neelam Rani is Associate Professor (Finance) at Indian Institute of Management Shillong.
Aakash Saxena, an alumnus of the institute, also contributed to this column.

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