Indian investors are waking up to the importance of having a liquid debt component in their portfolios. They are beginning to view debt mutual funds as a viable option to gain exposure to debt. Debt funds offer investors a debt investment option beyond bank deposits. They offer investors greater liquidity compared to holding individual bonds. Debt funds are also more tax efficient compared to individual bonds. They also provide a degree of stability to portfolios. This has seen participation by individual investors in debt markets increase.
But most debt fund investors lack clarity about the nature of debt mutual funds. They have a number of misconceptions about investing in them. This could lead to the development of unrealistic expectations from such funds. Be that in terms of returns they generate or their overall suitability for portfolios. This would ultimately lead to disappointment and suboptimal performance for investors. So today, I am going to focus on clearing common misconceptions surrounding debt mutual funds and show what we should actually expect from our debt mutual funds.
Debt funds have gained popularity among investors because they are seen as a substitute to bank deposits. Two investment products can be substitutes for each other when they have similar risk and return profiles. Bank deposits are fixed interest bearing instruments. They are not market linked. This makes them virtually risk free. A debt mutual fund is a market linked instrument. It has a market value of its own. The market value of a debt fund is affected by market forces of demand and supply. The market value of a debt fund therefore fluctuates regularly. Such changes in value can be tracked over a period of time.
This means that debt funds do carry a degree of incremental risk. They therefore compensate investors with a relatively higher return compared to bank deposits. This clearly means that debt mutual funds are not perfect substitutes for bank deposits. They are simply a more tax efficient avenue to gain exposure to debt. This is because they allow investors to avoid being taxed until the point of sale.
Theoretical finance propogates that bonds and debt funds lose value as interest rates rise, and vice versa. This is largely true in the fundamental sense, and is one of five fundamental bond valuation theorems.
But, the bond market in India today is progressively becoming deeper. This is due to increased participation in the bond markets from a wider variety of players. Therefore, the Indian bond markets are now subject to a much higher degree of speculation. And NAVs of debt all categories of debt mutual funds are bound to be affected by this. This means debt instruments are likely to be driven almost equally by fundamentals and speculation going forward. Investors must therefore not tie their assumptions to fundamental financial theory too strictly.
Debt is traditionally seen as a counterweight to equity owing to the low correlation between them. This leads investors to believe that debt products would insulate their portfolios against an equity market downturn. Debt is relatively less volatile than equity. But debt as an asset class can never perfectly insulate a portfolios against a drop in the equity markets. All asset classes are cyclical in nature. This means debt investments also go through a downswing from time to time.
Such a downswing cause a sharp drop in the value of debt instruments over a short period of time. This is similar to most other market linked assets. Therefore investors can only expect debt instruments to provide a degree of stability to the portfolio. They cannot expect absolute protection against a drop in portfolio value.
Some investors may look for incremental returns from debt funds by investing in credit risk funds. These are a category of debt funds that invest mainly in bonds of companies that are of an inferior quality in terms of their inability to meet their interest payments on time (technically called credit risk).
These funds make up for the lack of portfolio quality by offering investors a higher potential return. But taking on the incremental risk it demands makes very little sense. This is because debt is an asset class that is meant to give stability to the portfolio. Also, if one of the bonds in the portfolio of a credit risk fund were to default, the NAV of the fund would likely drop sharply. Any resulting losses would likely be permanent. Credit risk funds must therefore be avoided at all costs.
On the other end of the risk spectrum within the debt fund universe lie gilt funds. They enjoy a sovereign credit rating. This means that they are of the highest quality. And because these funds invest in bonds issued by state and central governments, there is virtual certainty with regard to the timeliness of interest payments. But virtual certainty does not imply absolute certainty. There is the always possibility (albeit very remote) of a sovereign default. Such a situation was most recently witnessed in Argentina in 2020.
Finally, it is important to pay attention to the average maturity period of the bonds in a debt mutual fund. The average maturity of a debt fund should be significantly lower than the term of the goal it is chosen for. For example, a debt fund with an average maturity of 1 year should be chosen for a goal that is at least 5 years away. Matching the average maturity of the fund to the term of the goal would be risky. This is because because individual bonds in the fund would have maturities that are much higher than the average. This would heighten volatility and increase portfolio risk.
Developing the right understanding of debt funds requires investors to realise that such funds cannot offer returns with the stability of a bank deposit. They would carry the risks associated with any other market linked asset class. They can only be expected to manage risk. But they cannot provide absolute protection against it. And most importantly, the average maturities of funds chosen must be mapped to the term of each goal. This would give investors enough of an understanding for them to consider investing in debt funds.