Deflated by poor returns Its too soon to give up on debt funds

Written by Brijesh Damodaran | Updated: Nov 5 2013, 15:08pm hrs
Debt mutual funds have, for long, been the remedy for risk-averse investors. From 2011 onwards and for a better part of 2013, returns delivered by debt mutual funds have rolled on. Coupled with foreign institutional investor (FII) inflows in the space and the spectre of rate cuts, returns were high.

As the rupee touched new lows in August and September and inflation became sticky, the Reserve Bank of India (RBI) hiked interest rates and the spikes in the yield turned the returns table. Even FIIs started withdrawing money from debt. Optimism turned into pessimism. For a fortnight, the returns from even liquid funds the category touted as the safest of the safe debt instruments delivered negative returns.

The approach

Debt funds play a great role in wealth creation and preservation. A herd approach, with the aim of maximising returns without understanding the requirement, caused a lot of pain to a majority of investors. The obsession with return maximisation, ignoring the risk appetite and product portfolio has brought grief. So, how does one now revisit the debt portfolio investment strategy

Asset allocation

Its crucial to understand why you are investing in debt mutual funds. Bank fixed deposit is the only instrument that gives guaranteed returns. Apart from this, just as in any other financial product, there is a risk-reward relationship.

Understand the debt instrument you are investing in. The thumb rule that you can use is to keep the time horizon and liquidity needs in mind. For liquid funds/ultra short-term funds, the investment horizon is 0-3 months. Investors must ensure that the fund portfolio consists of only AAA and above rated instruments with no exposure to gilt funds.

In short-term funds, the investment horizon is 3-6-9 months and, here too, the fund portfolio should consist of only AAA and above rated instruments, investing between 90 and 270 days horizon, with zero/minimal exposure to liquid funds. For dynamic bond funds, the fund portfolio should consist of only AAA rated instruments, investing between 90 and 270 days horizon, with zero/minimal exposure to liquid funds.

Credit rating

In a rising interest rate regime, the portfolio composition with a bias towards gilt would generate sub-optimal returns compared to an exposure to AAA rated corporate bonds. Again, the maturity period of the instruments held in the portfolio has an impact on the return generated. If these are very complicated, then either understand the product or stick to liquid mutual funds in the debt category.

Corporate bonds funds with an investment horizon of above 18 months work on similar lines like bond funds, but with a difference. Here the fund manager, at times, takes calculated calls on the credit rating of the instruments in the portfolio. It is normal to find AA- instruments in the portfolio. This allows the funds to generate the alpha in returns.

Again within the bond funds, you would have come across terms like duration and recurring funds. Typically, in recurring funds, if the investments are held till maturity, one can expect returns at the end of the investing period, in line with what was the stated at the beginning of the investment term. Duration funds are more actively managed and the calls of the fund manager have an impact on the return generated.

Once you know the distinction among debt instruments, you should make your investment decision. One of the advantages of debt mutual funds is capital gains. If held for more than a year, you are eligible for indexed capital gain/loss, which adds to the yield in portfolio, besides generating a tax advantage. On the other hand, bank fixed deposits are plain-vanilla products and tax benefits are not available.

The volatility and negative returns generated by debt mutual funds in the last quarter or so are not reasons enough for you to stay away from debt funds. Understanding your needs and then investing in a product is a definite way for both capital appreciation and preservation.

The writer is founder and managing partner of Zeus WealthWays LLP