How safe are debt funds now?

In the latest episode of Investors' Hangout, Dhirendra Kumar explains the issues facing bond funds and how you can reduce your risk while investing in them

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The credit worthiness of many prominent bond issuers is under clouds these days. Many debt mutual funds have also invested in them. Can you throw some light on the entire issue?

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Dhirendra: Yes, some recent credit issues and other events in the corporate world have caused a great deal of anxiety to fixed-income fund investors.

Debt funds invest in various kinds of bonds such as T-bills, commercial papers, certificate of deposits, etc. They are all graded in terms of quality which reflects in their credit rating. Lower the credit rating, higher the return and risk.

There have been some instances like the one we faced with Zee. Mutual funds invested in their bonds against the promoters' holdings in these companies as collateral. In case of Zee, its stock price came down significantly in a single day because of which there was a panic in the market as the value of the collateral went down substantially. Everybody became apprehensive.

But according to me, the things which we have seen with Zee, DHFL and Reliance ADAG are not alarming. Even if they are alarming, investors should understand the relative impact. The design of mutual funds is such that the investments by a particular fund company are spread across all kind of instruments. And then, exposure to a particular instrument is spread over different funds. So only one or two per cent of the money is exposed to it. Which means that even if the default happens, it is unlikely to be a complete blow up. The basic benefit of mutual fund is that you diversify your risk. And you are diversifying it here also.

In the worst case, even if there is a complete blow-up, all your money is unlikely to go in drain. There would be negotiations and there may be recovery after some time. Some collateral is also there. But you may have to compromise on short-term returns, say over a two-month period.

The news which we see tends to create an impression that the bond funds are going to crash tomorrow. But that is not the case. Bond fund industry is a large one and all these exposures put together will not aggregate to a significant proportion of it.

Would side-pocketing be of any help in the given situation?
Yes. It will be of great help. As a result of side pocketing, defaulting instruments will be taken off and kept in a side pocket. There will be a parallel fund, valued at zero. And the remaining fund will continue to run like any other normal fund. All the investors as of that day, will be entitled to any recovery that happens in the future.

In the given scenario, what is your take on bank deposits versus debt funds? Which is superior?
Historically, investors have sought assured returns and they get them in bank deposits. Bank deposits carry a perceived sovereign guarantee as Government of India doesn't let a bank fail. Compared to that, even if you are likely to get a higher return from bond funds, it is not assured. That causes anxiety to investors. Bond funds face this challenge. But their tax efficiency and the ability to convert your interest income to capital gains is highly advantageous if you hold your investments for more than three years.

Investors can reduce their risk in bond funds by investing in the appropriate category. For instance, liquid funds for a duration of a few weeks. Besides that, the principle to follow is that you should avoid taking unnecessary credit risk in pursuit of higher returns. Remember that a bond fund giving higher returns will need to assume higher risk. But you should not try to maximise your return from fixed-income funds as it will bring a greater amount of risk to your investment.

Click here, to register for the forthcoming episode of Investors' Hangout and post your question for Dhirendra Kumar.

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