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Debt funds are risky, too

Massive drops in the NAVs of some debt funds have made investors realise the risk in these funds. Here's how you can pick safe and sound debt funds

Debt funds are risky, too

An analysis of the daily rolling returns of five categories of debt funds that see high investor interest - low-duration, money-market, short-duration, corporate bond, and banking and PSU - shows that the number of instances of a debt-fund NAV dropping by 1 per cent or more in a single day has risen sharply in the last two years. It seems to have gone through the roof in 2019 and 2020 (see the chart below).

It is not just that the number of instances of massive NAV drops has risen, such falls have become much worse in the last couple of years. The graph below highlights the worst single-day returns of the worst performers across the five categories analysed.

Risk in the fixed-income space has always been dormant. Never before has the risk in the fixed-income space surfaced at this scale. Sure, there were such instances earlier also but then they were few and far between. For instance, in 2013, during taper tantrum, bond prices fell dramatically. This happened as the US Fed announced that it would taper its quantitative-easing programme (injecting money into the market by buying the Treasuries). At that time, the risk was systemic. However, over the last two to three years, it's more fund- or category-specific. In 2013, the regulator was able to control the spillover but this time the risk has surfaced quite dramatically.

The recent bad phase began when IL&FS, an infrastructure giant, defaulted on its bond payments. Soon after, debt-fund investors started witnessing frequent and massive markdowns in fund NAVs and segregations on the back of industry-wide defaults and downgrades. The winding up of six yield-oriented schemes of Franklin Templeton is the latest in this series of events.

There are many reasons for this trend. First is the tricky nature of the Indian debt markets. Unlike developed markets, the Indian debt market lacks depth. This lack of liquidity, especially for lower-rated bonds, creates a panic if a crisis is uncovered. Then comes the practices adopted by some AMCs, especially with respect to fixed maturity plans (FMPs), wherein the long-established principles of risk mitigation through diversification were grossly violated. Further, introduction of the valuation framework for sub-investment grade bonds also appears to have contributed to the volatility, though it has long-term benefits in terms of better transparency and faster realisation of the underlying credit issues.

Perhaps a bigger reason for the damage done was the lack of appreciation of risk. There was no distinction between a low-risk and a high-risk alternative. Investors looked at funds only from a return perspective. The most common interpretation was that the funds that generated high returns were better performers while those returning less were relatively poor. The risk side of the equation perhaps never got the attention it deserved. It was only when the risk manifested that everyone started acknowledging it.

What should investors do?
Value Research has always maintained that you should not get adventurous with your debt-fund investments. With fixed income, your first priority should be the safety of capital and then returns. If you want higher returns and are willing to take risk for those, then go for equity.

In order to assess the risk that your debt fund is taking, type the fund's name in the search bar above. This will open the fund page. Scroll down and you will find the credit-rating break-up of your fund's holdings (see the screenshot). The higher the allocation to lower-rated securities, the riskier the fund.

Another useful data point available on Value Research Online is the yield to maturity (YTM). YTM gives you a rough idea of what returns the fund will generate if all its underlying bonds were held till maturity. Funds with a high YTM tend to be riskier. Therefore, if you see a relatively high YTM, delve a little more into the fund details (see the screenshot below).

For fund details, you get detailed portfolio holdings. If you see individual bonds or issuers with substantial allocations in a fund portfolio, that should be a cause for concern. See the screenshot below.

In debt funds, the worst historical returns can also be a tell-tale sign as normally debt funds are expected to deliver stable performance. You can also get this on VRO. See the screenshot below. For instance, in the case of short-duration funds, you can look at the worst returns in any one-year period. For a liquid fund, this period could be a month. A history of delivering high negative returns could be a red flag, suggesting that at some point the fund had been in trouble.

Investors need to accept that risks in debt funds are for real. Further, they should understand the variations among funds. On the one hand, we have funds which assume greater risk in pursuit of returns and on the other, there are more conservative funds which do not assume much risk and so provide slightly more moderate returns. So, do acknowledge this variation while selecting funds.