Jul 26, 2013 06:58 PM IST | Source: Moneycontrol.com

Should you pull your money out of debt funds?

Debt fund NAVs have fallen across board after RBI‘s actions to reduce liquidity in the system. Debt funds which were seen as a safe haven, now is seen as volatile as the equity. Financial expert Kiran Telang advices investors on what should be done in current volatile situation.

Should you pull your money out of debt funds?

We are in midst of a debt market turmoil. The Reserve Bank of India has taken some actions to reduce liquidity in the system. This is done with an aim to stem the fall of the rupee. These actions are playing havoc with the bond yields. Debt fund NAVs have fallen across board. Funds holding long term securities are the worst hit. Debt funds have been shown to be safe investments as compared to equity. Nothing shows the risk of debt funds better than the situation today.

Debt funds carry debt securities of varying tenors. Every debt security has two components which add up to the income that can be generated from that security. A coupon which is the fixed interest that accrues or is paid at fixed intervals and the second is the bond price which fluctuates as per interest rate dynamics in the market. The coupon part is a steady accrual unless there is a default by the issuer of the security. Say you hold a bond of Rs 100 paying a coupon of 8% for 5 years. Now if the rates are cut, new bonds will be available with coupon of let’s say 7.75%. Hence the value of your bond increases as you are getting an interest that is better than what the market is offering currently. That means you can sell your bond in the market for more than Rs 100. Inversely if the new bonds are available at 8.25%, others will pay you less than Rs 100 for each bond. If your bond was a 10 year paper instead of a 5 year paper, it would face more such occasions when its price would fluctuate depending on the interest rates in the system. Hence a bond which is of longer tenure will be more volatile than a shorter tenure bond. If you decide to hold your bond for the entire 5 years, these ups and downs will not affect you. You will continue getting your 8% coupon and will get the principal of Rs 100 at the end of 5 years.

As debt funds work in a dynamic market where they are expected to account daily for the changing rates in the market, the NAVs change on a daily basis. The change is miniscule for these funds most of the times unless there is a drastic change in the interest rate as happened recently or there is a major credit default. It is ideal to get into a fund which has its average maturity aligned to your investment horizon. This way you reduce your risk. In case of volatility, if the fund holds the securities in its portfolio till maturity, it will ensure that it earns a return equivalent to its coupon. If you hold a fund which has average maturities that are different than your investment horizon, you will be exposed to volatility risk due to interest rate fluctuations.

In a situation such as the current one, the first principle is not to panic. It is panic that brings in more losses than anything else. People who panicked and sold their investments during the 2008 crash have lost lot of money. They will find it difficult to enter the stock market again. 

The second principle is that stick to your asset allocations. People who had proper asset allocations in place bought more equity in 2008 as their equity allocations would have fallen drastically. Hence they eventually gained. Similarly today when we are in midst of a bond market crash, this should be looked at as an opportunity to buy more into debt. A caveat here- do not be in a hurry to act. Let the events play out. There might be more news coming which you need to look at, before deciding on which way to go.

Going forward the interest rate cycle might change again and go in the earlier anticipated trajectory of interest rate cuts. It will be at that time that these funds will bounce back again. Even if there is no major bounce back, the coupons which will aggregate over a period of time will wipe out the losses that you see today in the portfolios. As against this if you redeem today, you make the notional loss into an actual loss.

In the current market there are opportunities available to take benefit of the hike in the short term rates. For those who can stomach the volatility, have the risk appetite and have a longer investment horizon, the long term debt funds are also a good place to enter.

If you have your asset allocation and goals in place and have invested accordingly, there is no need to worry about the sudden changes in the market. Focus on what you can control and do not bother about what is beyond your control.

- Kiran Telang
(The author is a member of The Financial Planners’ Guild, India (FPGI). FPGI is an association of Practicing Certified Financial Planners to create awareness about Financial Planning among the public, promote professional excellence and ensure high quality practice standards.)

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