While debt funds, unlike fixed deposits and small saving schemes are also subject to market risk, though less than equity funds, the return expectation is commensurately higher than traditional products over the same tenure.
Lately I have been meeting a lot of relatives, friends & acquaintances, grappling about a common concern of what to do now with the new normal of low interest rates on fixed deposits & small saving schemes. It is very disturbing for many because of their investment style and return expectations from the past. Invest in mutual funds, I said. ‘Don’t mutual funds invest in stocks?’, ‘Aren’t mutual funds risky?’, ‘Will I get fixed returns?’ they asked. Mutual Funds as a product offering which can invest in equity, debt, commodities and even a combination of them depending on the objective of the fund and hence investors across risk profiles, goals & time horizon will find a suitable product, I said.
Why Debt Funds
(1) Tenure of investment – Regardless of your time horizon, there is a suitable debt mutual fund available.
(2) Tax Efficiency – This is the reason why most FD investors will appreciate debt mutual funds. If you invest for less than 3 years, the gains are taxed at the income tax slab rate like in an FD but if you hold the investment for more than 3 years, the gains are taxed at 20% (even if you are in the 30% tax bracket) and that too not on the full gains but only on the gains that exceed inflation. So if you earn 8% on the debt fund and inflation (measured by CII) increases by 5% in the same period, you pay 20% tax only on 3% (8%-5%), which is 0.6% (20%*3%) versus 2.4% (8%*30%) 4 times higher in an FD investment. The post tax return on a debt mutual fund is far superior to a FD, even when we are assuming that the debt fund will generate returns similar to the traditional products.
(3) Possibility of higher returns – Return is a function of calculative risk taken. It is not that FD does not have any risk. It is presumed to have no risk, which may not be entirely true.
Let me highlight a couple of risks that all fixed income instruments have.
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(a) Interest Rate Risk – Lets assume you have invested in a FD paying 7.5% return over 3 years. What if interest rates in the market move up? The same institutions will then pay 8% to the new depositor vs you still receiving 7.5%.
(b) Reinvestment Risk – In the same case above, if the interest rate moves down, you will get a lower rate from the same institution, when you try and reinvest after 3 years. This is the challenge most traditional product investors are currently facing and will continue to face in the future. Over the last 15 years, investors have seen bank FD’s paying as high as 12% as well but the average over the last 15 years is 8.5% on the bank FD.
(c) Inflation Risk – While the above investment matures after 3 years, you realize that inflation has moved up by 5% in the same period. The net result on your investment is not 7.5% but only 2.5%, which we call as the real rate of return. Most of the times you will observe that inflation is increasing at a pace faster than the returns offered on the FD, generating negative real return.
All the above are risks that one has to take irrespective of the fixed income instrument they invest in. While debt funds, unlike fixed deposits and small saving schemes are also subject to market risk, though less than equity funds, the return expectation is commensurately higher than traditional products over the same tenure. In the below chart you will see how various debt fund categories have performed over the last 3 years.
Risks in a Debt Mutual Fund
Interest Rate Risk – Debt funds invest in various fixed income instruments issued by the government, banks & financial institutions, RBI, corporates etc., which are mostly traded on the exchange helping the fund to generate higher returns over the interest (coupon) committed. The price of the traded fixed income instrument is inversely proportional to the market interest rate. Lets say the debt fund bought a government bond paying a coupon (interest rate) of 8% and is now trading in the market. In the future when interest rates drop, government would issue a new bond at a lower interest rate, say 7.5%. Everything else kept constant, it’s logical to buy the old listed bond, which pays higher interest rate of 8% than the new bond and hence the price of the old bond increases because of higher demand, generating capital gains for the debt fund over and above the 8% coupon. Interest rate risk in the bond fund is captured by modified duration. Higher the modified duration, higher is the risk and higher are the return expectations. If a fund has a modified duration 2, it means for every 1% drop in market interest rate, the debt fund will generate positive 2% returns over and above the YTM (investors can understand this as the coupon/interest rate). The table below will help you understand the interest rate risk profile of various debt funds.
Conclusion – If you want to take lower risk, select funds with lower modified duration.
Credit Risk – The fixed income instruments in which the debt funds invest are credit rated. Credit rating agencies give a rating to all these instruments showcasing the credit worthiness of the issuer to pay interest and return the principal. Higher the credit rating, lower the risk and hence lower is the coupon the issuer pays and vice versa. So let’s say, if the debt fund buys an instrument, which is highly credit rated at AAA, fund will receive a lower coupon rate, as the risk is low. Unfortunately, in the future if the credit rating agency reduces the credit rating to AA, the debt fund will still receive the same coupon that was committed earlier but the risk has increased and hence this fixed income instrument will start trading at a lower price on the exchange, incurring capital loss to the debt fund. The inverse is also true. The point to be noted is that the capital loss is only notional. If the debt fund does not sell the fixed income instrument in the market and continues to hold, it still receives the coupons committed as normal. The table below will help you understand the credit risk profile of various debt funds.
Conclusion – To reduce the risk, select funds, which invest in high credit rated products.
The right debt fund for you
The answer to which debt fund you should invest in, depends on your goal and risk profile. If your investment horizon is less than 3 months, the most ideal option is investing in a liquid fund. Having said that, you can invest in any other scheme from the list below, but the risk profile of the fund may increase if invested for less than the ideal investment horizon. Lets say you choose to invest in corporate bond funds for 3 months to generate higher returns, you have to understand that the risk will be higher than normally holding the corporate bond fund, which is medium if held for more than 2 years. The below table will give you a clear snapshot of which fund debt fund suits your requirement.
The writer is CEO – Sykes & Ray Financial Planners