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A Debt Fund Hazard

Most investors use the wrong strategy to invest in debt funds, but the government’s rate intent has raised the risk

Interest rates in the Indian economy have an unusually cloudy outlook currently. There are equally legitimate forces that could pull rates up or down. On the one hand, we’ve just been handed a Union budget that has painted a big upward-pointing arrow on interest rates. The government needs money, and lots of it. It hardly seems possible for it to squeeze out so much borrowing out of the same economic space and not starve private borrowers off reasonably-priced funds.

On the other hand, we hear the declared intentions from many worthies that interest rates won’t be allowed to go up and that the funds needed for growth will remain available to the private sector. The finance minister (FM) had said so. Some of his inner circle of economic advisors have said so, and now the chairman of the State Bank of India has also said so. You could be forgiven for assuming that the motive for these statements is more to strike a politically expedient posture than anything else. The FM and company know, as everyone else does, that money is going to be expensive and tight, at least till growth takes off in a big way. However, this posturing hasn’t worked in shifting sentiment. There’s no one in industry who believes that the availability and interest rates of debt are going to be easy. Businesses are scaling their short- and medium-term plans on expectation of a high-interest rate scenario and that’s going to affect growth until someone has proof of the opposite.

As individuals, this outlook may affect us in different ways, but as investors, it should have a sharp impact on our attitude towards investing in debt funds. Rising or uncertain interest rates have the worst impact on all, but the shorter-term debt funds. If you were looking to debt funds for stability, then short-term funds are your only viable option.

This brings us to the widespread misconception rife among retail investors. What are debt funds for? Many individual investors think of debt funds as equivalent to (or better substitutes for) fixed-income investments. They invest in these funds for longish periods of time and leave them there, as they would with a bank deposit or their PPF account. This isn't a good thing to do. These funds are far from being suitable as long-term fixed income investments for conservative individual investors.

In periods longer then a few months, debt funds rarely give returns that are superior to what an individual would get from more suitable asset types. Currently, the average three year returns for most types of debt funds range from 6 per cent to 8.5 per cent per annum. There's no way that this is a better alternative to bank FDs or even better, a sovereign-guaranteed asset like a Post Office deposit. In fact I've always thought that the Indian post office savings system is a hidden gem that is severely under-utilised by the typical urban investor. Good returns, along with government-guaranteed safety and no tax deduction at source (TDS) makes it far superior to many other ways of earning a decent and safe fixed-income return. It is true that debt funds are far more tax-efficient than bank deposits. However, if you look at the actual quantum of the difference this causes, then you’ll see that it doesn’t become a serious amount at the normal corpus that non-high net worth (HNI) investors have.

Debt investors should be moving between different types of debt funds as the economy goes through interest rate cycles. In times of tight or uncertain interest rates they should be in shorter-term funds. In times of falling rates they should be in longer-term funds. All this makes sense only for professional investors, like treasury managers of corporations who need to park funds in a risk-less manner for specific periods of time. This active investment management is actually what investors practice for equity funds where they should just invest and forget.