Net asset values (NAVs) of some debt funds have in recent times registered losses, shocking many investors. Yes, as they invest in market related instruments, debt funds can make losses when the risks in their bond portfolios materialise.
For investors who own debt funds or are looking to buy them, the important question to ask is about the period it takes for the fund to recoup the loss. Value Research ran a rolling return analysis of debt funds returns to understand the proportion of losses an investor can incur over different holding periods.
Our data shows that the chances of losses in debt funds, be it in a category like credit opportunities, dynamic bond, gilt or liquid, diminishes to virtually zero if your holding period is one year or more.
Debt fund NAVs usually reflect the market price of the bonds the scheme holds. Most of the times, price declines are triggered by interest rate changes. However, less frequently, NAV ups and downs could also be due to credit rating changes on the bonds held.
Below is a table showing the probability of losses for each category of debt fund held for different tenures. This data is compiled using rolling returns on the entire category of debt funds for different time frames, over the last 5 years. Rolling returns are the annualized average return for the stated period. They are extremely useful for examining the behaviour of returns for holding periods similar to those actually used by investors.
As you can see from the table, for each category, the chance of losses slowly reduces as timeframe increases. Dynamic bond funds, for example, which react to interest rate changes when they take duration calls, have seen 34% of losses if you had a fleeting 1-day time horizon. If you hold them for 1 month, the chance of losses drops to 23% and if you hold for 3 months, the loss percentage drops below 15%. Beyond a year, it is practically zero. Be it gilt funds or income schemes, there is a high proportion of losses if somebody parks money for 1 day. But the moment you cross the threshold of 3 or 6 months, these debt funds manage to reduce the probability of losses quite sharply.
Even less risky categories of debt funds, like short term funds can register losses. The proportion of losses on 1-day tenure for short term debt funds is 14.83%. But if your tenure is 1 month of more, the loss percentage drops to less than 4%. If you hold short term funds for 6 months, the chance of losses falls to almost zero.
Mahendra Jajoo, Head-Fixed Income, Mirae Asset Global Investments (India) said: "Investors with long term investible allocation to debt , in our view, should aim to maximize returns. As your analysis suggests, practically, principal has been safe beyond investment horizon of 1 year. Thus by reconciling to short term volatility and being able to tolerate negative returns in the interim period, long term investors can aim to meaningfully enhance returns on debt investments. It will also incrementally add by way of power of compounding"
R. Sivakumar, Head - Fixed Income, Axis MF said: "Investing in debt carries some risk, though the probability of losing money and quantum of downside is lower than equities. Fixed income funds come with a range of maturity profiles, with longer maturity funds associated with higher risk than shorter maturity funds. It is therefore important to match the investment horizon of investment with the risk in the fund. For instance income funds may not be suitable for short term parking of funds."
All this not to say that losses on debt funds are acceptable or that it doesn't hurt investors in debt funds. But the above data shows that holding a fund for over a year can help you minimise the risk of a loss. In any case, debt funds turn tax efficient for investors only if held for over 3 years because of the indexation benefit on capital gains.
While there are (and will be) instances where debt funds have been hit hard because of poor quality papers they hold, the pros for investing in debt funds seem to outweigh the cons.