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6 traps to avoid with debt funds

With plummeting returns on traditionally safe instruments like bank FDs & post-office schemes, many investors are tempted to shift to debt funds

6 traps to avoid with debt funds

If you're a saver, pensioner or even just a conservative investor, you would have certainly noticed that interest rates in India are tumbling like ninepins. In the last four years, the Reserve Bank of India (RBI) has cut its benchmark repo rate from 8 per cent to 6.25 per cent, a 1.75 percentage-point slash.

Interest rates offered by banks on their one- to five-year fixed deposits (FDs), which ruled at 8 to 9 per cent in October 2014, have fallen to 6.60-7.25 per cent by July 2018. Rates on post-office time deposits have plunged from 8.4-8.5 per cent to 6.60-7.40 per cent and those on the popular Post Office Monthly Income Scheme (POMIS) from 8.4 to 7.30 per cent in the same four-year period.

This falling interest-rate cycle has obviously hit fixed-income investors hard. If you are a pensioner depending on FDs for your monthly income or even a salary-earner who supplements his pay cheque with bank or post-office interest, your income is likely to have shrunk sharply. High tax rates on these debt investments deal a further blow to your returns. For an investor in the 20 or 30 per cent tax bracket, a 7 per cent annual interest on the bank FD translates into just a 5-5.5 per cent post-tax return in his hands. This barely matches consumer price inflation.

The move to debt
All this is prompting many investors to consider an alternative that they never did before - moving their safe money into debt mutual funds. If you check out the average returns on debt mutual funds recently, this decision will in fact seem like a no-brainer, for even as banks were busy slashing their interest rates, debt funds have delivered decent returns.

But if you are looking to shift all your safe money into debt mutual funds, hoping for a repeat of these returns, that's like driving your car super fast on a highway while looking into the rear-view mirror. For one, the recent returns of debt funds are not indicative of the returns over the next one, three or five years. And two, to look at the returns alone and ignore risks while you are investing in any instrument is not a wise move.

No, we aren't arguing that all conservative investors and pensioners must stick only to bank deposits or POMIS and be happy with below-inflation returns. For many of these investors, it does make sense to shift some money into debt mutual funds. But they must do so after fully understanding how debt funds manage their risks and returns.

Here are 6 specific traps that investors considering a shift into debt funds must understand and avoid.

1. Investing based on past returns
If you’re shifting from bank FDs into debt funds today, don’t do it based on past returns. Moderate your return expectations. And don’t choose your fund category based on recent returns. 

2. Choosing funds by holding period
To choose the debt-fund category that best suits you, keep your risk profile in mind. If you hate ups and downs in your debt-fund returns, stick to liquid or, at best, ultra-short-term funds. If you can take volatility, consider income or dynamic-bond funds. Add long-term gilt funds to your portfolio only if you can gauge the direction of interest rates and don’t mind occasional losses.

3. Thinking risk ensures high returns
Don’t assume that taking on higher risks in debt funds will automatically bring on higher returns. If you have the appetite to take on risks through credit-opportunities, dynamic bond, income or long-term-gilt funds, look at the track record of the fund over two previous interest rate cycles to gauge their ability to handle risk. A simple way to do this is to take stock of the best and worst one-year returns managed by the fund in the last eight years. Gauge if you are comfortable with such a high volatility in your returns as a fixed-income investor. 

4. Ignoring the costs
Don’t forget to look at expense ratios just because returns look good after charging them. The expense ratio should be a key factor not only in choosing within a category of funds but also in opting for the type of scheme you want to invest in. 

5. Sleeping on your debt funds
Check on your debt funds once in every six months. Measure both calendar and trailing three-year returns. Switch to a better performer if your fund trails the category for three years running. But looking at returns in relation to risks is extremely important, too. Consider switching out of your debt scheme if the average maturity or portfolio’s credit profile have changed materially since your investment. 

6. Investing solely for tax breaks
Don’t make the shift from bank FDs or post-office schemes to debt funds without factoring in the risks. But if you are comfortable with the risks, debt funds can prove a great parking ground for your three-year-plus money. Go for the growth option to get tax-efficient, inflation-adjusted returns from your debt funds. For those with regular income needs, opting for systematic withdrawal plans from the growth option after a three-year holding period is the ideal way to earn tax-efficient returns.

This column appeared in the December 2016 Issue of Mutual Fund Insight.