Hard Questions for Debt Fund Investors | Value Research The past three weeks have shown debt fund investors that stable performance can’t be expected in unstable times
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Hard Questions for Debt Fund Investors

The past three weeks have shown debt fund investors that stable performance can’t be expected in unstable times

Should we continue to invest in debt funds? That’s the question being asked by many an investor right now. While professional investors and corporate CFOs who use debt funds to park cash may have an understanding of the upheavals that are taking place, small investors who have started using debt funds are a bewildered lot. Investors have an expectation that debt funds will give stable returns even over short periods of time.

Investors’ understanding is that debt funds can exhibit volatility from day to day but expect this to be smoothed out over the course of a few days. They expect this to be so for the longer maturity debt funds. However, for shorter maturity debt funds, they have an expectation that returns will be more or less in a straight line. For liquid funds, which are subject to special mandatory constraints that should limit their volatility, investors expect that there should never be a negative day.

But things have worked out very different since the last week of May. Three weeks ago, I wrote about how Indian debt fund investors had faced shock losses because the massive pull-out by FIIs. The debt fund trend turned after May 22nd and by June 12th, some types of debt funds had recorded far worse returns than the worst their investors had any expectation of. During that time, long and medium term government security funds (Gilt Funds) recorded a loss of 1.11 per cent and the general category of income funds recorded a loss of 0.84 per cent. These losses were a result of FII’s sale of bonds and further sellouts that cascaded from that.

However, last week has brought another series of shocks that left no category untouched. Between Monday and Wednesday, gilt funds lost 2.14 per cent, general income funds 1.67 per cent. Even liquid funds, which were thought to be immune from even a day of losses, lost an average of 0.18 per cent. One the 16th of May, some liquid funds lost as much as 0.38 per cent. Of course, the primary cause of these losses was the Reserve Bank’s action of tightening the supply and rate of its overnight funding facility for banks. This fostered a widespread collapse in the value of bonds and resulted in losses for all types of funds.

Obviously, these last four weeks have left investors shaken. Should they continue to trust the stability of debt funds? But the answer is actually straightforward. Investors will have to pay a little more attention to the maturity horizons of debt funds and what they imply about their period of holding. You could ignore this when interest rates and economic macros are behaving themselves but India is not in that sort of a situation now and won’t be for a long time.

Gilts and longer maturity funds can be expected to smooth out the worst volatility only over a period of several months to a year. Even so, they are vulnerable to shifts in interest rates. Shorter-term funds can have a horizon of a few weeks. However, liquid funds can be expected to straightline in at most a week even in the worst case. This is actually true even in the current upheaval. The reforms that SEBI had instituted in liquid funds’ investment and valuation norms have functioned well. The problem has been with investors who had imagined liquid funds to be immune to any losses, even on a single day.

The trickiest problem is that of dynamic funds, where the fund manager is supposed to decide whether the fund is supposed to change the composition of the fund based on interest rate expectations. Unfortunately, this promise has not been realised and from the 24th May till now, dynamic funds have performed terribly, losing an average of 3 per cent. Investors need to seriously reevaluate the way dynamic funds have failed to deliver.

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