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4 things that debt fund investors should consider

Debt fund investing is not as easy as pie. Keep these factors in mind while evaluating your debt portfolio

4 things that debt fund investors should consider

Given the nasty surprises that the Indian debt market has sprung on mutual-fund investors in the last couple of years, what should they now do? Well, they should rethink their debt-fund portfolios based on the following heads.

Timing matters for duration
It is conventional wisdom that equity investments require good timing to pay off, while debt investments don't. But the increasing volatility in Indian bond markets, and the fact that interest rates are becoming harder to predict, suggests that funds which play the duration game are likely to experience high variability in their returns from year to year.

This pretty much holds good for income funds and dynamic bond funds, too, as both the categories of funds have been almost as aggressive as plain vanilla gilt funds in adding duration in the last couple of years.

To find out the extent of volatility in long-term debt-fund returns over the last ten years, we ran a rolling-return analysis (three years at a time) of the top ten schemes based on the performance from gilt funds, income funds and dynamic bond funds, the fund categories which usually take duration calls, at monthly intervals. The results are eye-opening.

For investors who held on for three years at a time, long-term and medium-term gilt funds have delivered returns that could range anywhere between 1.78 per cent CAGR and a 15.1 per cent CAGR in the last ten years (Figure 1).

The range of returns was narrower for income funds. But their three-year rolling returns still varied from 4 to 12.7 per cent.

Dynamic bond funds, which are supposed to navigate rates more smoothly, also saw quite a lot of volatility in their returns; they ranged from 3.75 per cent to 11.6 per cent. In fact, even gilt funds of the short-term variety saw their returns fluctuating from 3.4 to 10.1 per cent!

What this suggests is that if you enter duration funds at the wrong time, there's a good chance you'll be earning much less than bank-FD returns that all retail investors like to target.

One way to avoid this, if you are a savvy investor, would be to track the ten-year G-sec quite closely. History suggests that the G-sec has usually peaked out at about the 9 per cent mark in recent rate cycles and bottomed out at 6 per cent or so. Therefore, if you are looking to add big exposure to long-term gilt or income funds, doing it closer to the 9 per cent mark may yield you better returns. The closer market yields get to the 6 per cent mark, the better it may be to avoid these funds.

The shorter the better
But if you have neither the time nor the ability to watch over market yields, avoid duration calls and keep to shorter-term debt funds.

Short-term, ultra short-term and liquid funds offer a pretty good deal. A rolling-return analysis of these categories for the last ten years shows that the maximum returns they have managed for three-year periods are 10.9, 9.6 and 9.5 per cent, respectively (Figure 1).

4 things that debt fund investors should consider

While these returns may not be sustainable (they may decline if interest rates in the economy fall further), the good part is that the minimum returns they have managed are 6.2 per cent, 7.9 per cent and 6.9 per cent. Two factors favour short-term and liquid debt funds. One, due to their focus on very short-term instruments, these funds take less of a hit from an unexpected spike in interest rates. They also carry lower credit risk than credit or income funds as they stick to very short-term corporate instruments. Two, the expense ratios for these funds also tend to be much lower than those for gilt, income or credit funds.

This comparison suggests that for conservative fixed-income investors who are looking for more 'fixed' returns, short-term-fund and liquid-fund categories are the best bets.

Cautious on credit
For debt-fund investors who are spooked by the volatility in gilt returns, credit-opportunities funds may still appear to be a good option, with this category managing a 9 per cent plus return in four of the last five years and a healthy trailing return of 8.6 per cent in the last one year.

But recent episodes of rating downgrades and their impact on some debt funds like the ones run by JPMorgan AMC show that the risks carried by a credit-opportunities fund are not readily visible to investors.

If higher volatility due to market swings is the bane of funds which take duration calls, investors in credit-opportunities funds can suffer sudden jolts to the NAV as a result of rating downgrades. The poor liquidity in the Indian bond market and the fact that most institutions like to invest only in AAA-rated or sovereign bonds also enhances the risks in such funds. Should they face any incidence of sharp downgrade, open-ended funds may find it not so easy to exit their lower-rated instruments at the quoted price.

Therefore, investors who have hitherto been tempted by the relatively high returns of credit funds should recognise that there's no free lunch in the bond markets, just as there's none in the equity markets. If a fund is consistently delivering higher returns from credit calls, that probably goes with a matching risk profile.

This again calls for higher due diligence from investors willing to play this game. Rather than investing solely on the basis of past returns, factors such as the rating profile of a fund's portfolio, the yield to maturity (the higher it is, the riskier the fund) and the concentration in individual bonds and sectors must be considered.

If you are one of those investors who often bet on lower-rated corporate FDs in the hope of earning higher interest rates, credit-opportunities funds are a better bet for you as they offer better diversification and risk control.

But a plain vanilla bank-FD investor may not be prepared for the risks in these funds.

Stretch your holding period
With timing becoming more important in long-term funds and corporate bond funds getting vulnerable to rating changes, it has also become important for debt-fund investors to stretch their investment horizons. Already, changes in the holding period for debt funds eligible for long-term capital-gains tax had forced many investors to lengthen their debt-investment horizons to three years plus in the last couple of years. Now, a longer holding period for debt schemes has become essential for a better return experience, too. In duration funds, a longer holding period can help the investor ride out an entire rate cycle, thus recouping any losses made during a period of rising rates. In credit funds, a longer horizon may help the fund manager rebuild his portfolio and recoup losses, if any, from a bond downgrade or even default.

In fact, the rolling-return analysis shows that quite a few categories of debt funds delivered fractional returns or even losses for some one-year periods. But holding them for three years at a time not only helped investors avoid losses on such ultra-low returns, it also propped up their return experience over the long term.