Debt funds obviously generate extra returns by taking some additional risk
During the last few years, people got attracted to debt funds as a viable investment option in the fixed income space. But the recent problems have shaken some of the confidence of investors.
Being an advisor, I regularly talk to my clients and prospective ones about this. Many show signs of discomfort with these funds and how negative surprises seem to be becoming more frequent.
And I think this discomfort and unhappiness that debt fund investors have is based on the premise that they never expected this to happen. Why? Because, for them, equity was always a risky bet. It could go up or it could go down. But they had a belief that debt funds were ‘completely safe’. And if something is safe, how could it go wrong?
But the problem I think was with the expectations with the product (i.e., debt fund) and not in the product itself.
Why do people invest in debt funds?
Many do it to get better post-tax returns than what other ‘seemingly’ risk-free instruments such as FDs offer. Right? So the idea is to get more.
And debt funds, backed by past performances, did seem to be suitable candidates.
But think about it: if an investment is offering more than the risk-free rate of return (like FD), then it is obviously generating the extra return by taking some additional risk. Taking risk has its rewards, no doubt. But a problem with risk-taking is that it also has occasional and more importantly unexpected downsides.
For example: Let’s say a simple FD offers 6 per cent. Now, you want more. So you do your research (or talk to advisors) and decide to go for a debt fund as its average past return was about 7.5 per cent.
This FD may give 6 per cent, 6 per cent, 6 per cent, 6 per cent and 6 per cent over a five-year period.
But people built similar expectations from debt funds. Investors expect the debt fund to give 7.5 per cent, 7.5 per cent, 7.5 per cent, 7.5 per cent and 7.5 per cent too.
But that’s not how the product works.
It will instead give, say, 6.9 per cent, 7.8 per cent, 8.5 per cent, 8.9 per cent and 5.4 per cent.
So, you will not get the same average returns every year.
Set the right expectations
Debt funds are still good vehicles for investing in the fixed income space. But you should not have expectation getting FD-like returns from them. You will get better post-tax returns than FDs over a period of time. But every once in a while, there will be poor returns.
Having said all this about the structural limitations of debt funds, associated volatility and how it impacts the return profile depending on the duration, let me say something else too.
Like equity funds, even debt funds are managed by fund managers. So being humans, at times, their choice/investment in debt papers would go wrong and this will have an impact on the returns. So, even within the debt funds space (categories), there will be funds that are over-performing and there will be funds that are underperforming.
If you are an ultra-conservative saver looking for no-risk, complete safety and absolutely no volatility, then stick to FDs.
And if you want to keep your life simple, then stick with a limited category of debt funds that have regulatory limits on their risk-taking freedom. So you run your debt portfolio with low-risk intent and if you have to take risks for alpha or extra returns, you only do it with equity funds. You don’t be adventurous with debt funds.
The potential for debt funds to give higher-than-FD returns remains intact. And the tax advantage (indexation benefit, etc.) is still available. But don’t be under the assumption that debt funds are 100 per cent safe. Debt funds carry risk. And this is something that many investors ignore or forgot. So, manage your expectations and risk appetite.
(The writer is the founder of StableInvestor.com)