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Why debt funds still make sense

In spite of the recent turmoil, debt funds still deserve a place in your portfolio. Here is why


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Whenever Indian bond markets are caught off-guard by unexpected credit events, debt mutual funds usually turn the favourite punching bags of the media and the analyst community. This time around too, as defaults and downgrades have churned up the debt market in the past year, there's been strident criticism of mutual funds.

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But many of the issues that mutual funds are hauled over the coals for - their reliance on credit ratings, high exposure to NBFCs, their illiquid exposures to corporate bonds and the difficulty of recovering money from promoters - stem from the imperfections of the Indian debt market itself, which has a long way to go before it mimics the debt markets in developed markets.

Indian debt fund managers, as a class, have in fact done a reasonably good job of managing credit risks compared to other lenders such as banks. While domestic banks are today grappling with bad loans amounting to 12 per cent of their cumulative loan book, credit events in the mutual fund industry have affected just 1-2 per cent of the assets managed by debt funds.

Mutual funds are also far more tightly regulated by the ever-vigilant SEBI in terms of disclosures and mark-to-market valuation norms. Monthly portfolio disclosures offered by mutual funds put a lot of data on the industry's wrong calls in the public domain. The open-end structure of most debt funds and high institutional participation also make for high accountability compared to other bond-market participants who invest retail money. You hear a lot about fund exposures to IL&FS, but did you know that domestic banks' exposure to IL&FS is at 16 times that of the mutual fund industry? Or that LIC, private-sector insurers, the EPFO and dozens of private trusts managing PF money are also sitting on dud IL&FS paper?

The size of the problem
Therefore, before you get unduly panicky at all the noise around mutual fund exposures to defaulting companies, it is good to get some perspective on the exact size of the problem. A deep dive by Value Research into the rating composition of all the debt schemes in operation (both open-end and closed-end) as of end March 2019 showed that for every Rs 100 in assets managed by debt funds, Rs 15 was parked in safe government securities. Of the remaining Rs 85 invested in corporate bonds, Rs 60 was in either AAA or A1 rated bonds, Rs 11 in AA rated bonds and Rs 8 in cash and call money markets. In effect, bonds rated A or below made up just Rs 6 out of every Rs 100 invested in debt funds. Much of this exposure figures in credit-risk funds or FMPs mandated to take credit risks.

All this is not to say that defaults or downgrades, when they crop up, have no impact on debt-fund investors. For investors in individual schemes that have these bonds, credit events can be quite debilitating as they mean the loss of hard-earned returns as well as capital on occasion.

Where debt funds score
But the relatively limited scale of the problem suggests that retail investors would be losers if they throw the baby out with the bathwater and take to completely avoiding debt funds, owing to the noise around recent events.

Let's not forget the three aspects on which debt mutual funds score over alternatives.

One, while most fixed-income options in India suffer tax on their returns based on the income-tax slab rate, debt mutual funds are the rare instrument which is subject to tax after adjusting returns for inflation. If held for three years or more, returns on debt mutual fund NAVs are subject to long-term capital-gains tax at 20 per cent, after adjusting your original cost for the inflation index. This allows you to retain more of your returns from debt funds, when compared to bank deposits as well as most small-savings schemes (save the PPF and the NSC).

Two, the ability to exit an investment at any time of your choice at a transparent price is a critical attribute, too. Open-end debt funds offer anytime liquidity at a transparent NAV.

Three, diversification is also a little-appreciated attribute on which debt funds score over other fixed-income options. Debt funds, even the ones that take on credit risk, offer you a risk-controlled route to seeking high yields by owning a diversified portfolio of bonds. Fund managers, being large lenders to corporates, also carry a far greater clout than individual investors to negotiate adequately high interest rates for the risks taken and to realise their loans in the event of a default.

What to do
So accepting that market risks are a part and parcel of debt-fund investing and that they're never going to be as safe as small-savings schemes, what can you do to lower the risks in your debt fund portfolio while reaping their benefits?

1. Avoid concentration
Many experts advising retail investors on debt-fund selection today ask them to take a deep dive into the portfolios of their schemes to check if they own risky bonds. But it is quite unrealistic to expect a retail investor looking into a debt-scheme portfolio to know at once that an investment in Konti Infrapower is a promoter loan against shares or that Hazaribagh Ranchi Expressway is an IL&FS company.

Bonds with such uncommon names are quite common in debt-fund portfolios. Therefore, instead of trying to second-guess a fund manager's credit calls, the next best thing for every debt-fund investor to do is to screen for and avoid concentration risks in debt-fund portfolios. If your fund owns corporate bonds, simply check the scheme's top weight in an individual bond. If the top holding exceeds 5 per cent, it's a concentrated exposure. If holdings are well diversified, with no single security topping 5 per cent, it's a safer fund to own.

2. Don't chase returns
If you're looking to avoid credit risks in debt funds, stay away from the temptation to invest in funds that are topping the category chart or offering much higher portfolio yield to maturity (YTM) than their peers. They are sure to be taking on extra risks to get to that return.

In funds that invest in long-term bonds (gilt or medium/long-duration funds), avoid rushing into them after a year or two of blockbuster returns. Blockbuster returns on long-duration funds usually indicate that the fund has been packing its portfolio with long-term bonds when rates were falling. If rates reverse direction, the same funds will also be topping the loss-makers table owing to high rate risks they took on.

Assessing the category returns on debt funds, there's not a very big difference between the returns on debt funds that take on low credit and duration risks and the other categories that pack their portfolios with riskier bond bets. Choosing your bond funds based on a moderate YTM and a portfolio maturity of less than three years usually works well to keep you away from the worst of credit or duration risks across market conditions.

3. Be flexible about maturity
Finally, the recent episodes with FMPs drive home the point that, just like equity markets, debt markets also go through cycles, where there are good times to enter and exit. Therefore, since debt funds are market-linked, they are not ideal to deliver returns by a finite maturity date.

If your debt fund's bets on duration or credit go wrong, it often makes sense to simply hang on until the interest-rate cycle turns or the scheme is able to recoup its bad calls on one instrument with better ones on others. In any case, the taxation of debt funds makes it critical for you to hold onto your debt funds for a minimum of three years. After recent events, you should be prepared to stretch your holdings even longer if you happen to catch the debt market cycle at a particularly inopportune time.

 
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