DEBT funds have always been considered ‘safe’ by investors. But the last couple of years have shaken this belief. Dramatic NAV declines in August 2013 made us all aware of the interest rate risk inherent in debt funds that could lead to capital losses. And, now, August 2015 has highlighted, painfully for some, the element of credit risk. Even some corporate investors have been taken by surprise.
Understanding how your fund invests your money is crucial to ensuring that debt funds remain safe for you. It helps that these risks are well known to experts and, therefore, techniques to manage these risks are
Credit risk as cornerstone of debt fund investing
In our role as an advisor, we have always focused disproportionately on credit risk while recommending debt funds.
This comes from our belief that investors in debt funds are not looking for maximising returns — for that, they would invest in equities — but for safety of capital for short-term goals. Hence, our return benchmark is a bank fixed deposit (FD) and the objective is to achieve returns that are at par with bank FDs at a credit risk that is also almost the same. In this context, the motivation (and excess return) comes from tax-efficiency of debt funds vs bank FDs.
Returns often don’t match credit risk
The conventional wisdom is that a fund that takes more risk (by investing in lower rated bonds, for example) provides a higher return. But while developing our algorithm for recommending debt funds, we discovered that the risk being taken by a debt fund is quite often not linked with the return. We computed a blended risk score by taking a risk-weighted average of the funds’ portfolio and we found a number of funds taking high credit risk, but providing lower returns. We also found a few that provide high historical returns with lower credit risk.
So, how do you pick a debt fund that’s ‘safe’
We believe that long-term consistency of returns indicate how interest rate risk is managed by funds in delivering a return similar to bank FDs. So, pick funds that have consistent return performance over a period of 4-5 years. To minimise credit risk, analyse the portfolio of the fund. The fund houses are required to disclose this information every month. Now, pick funds that rank high on both criteria — consistency of return and portfolio with good credit.
Another fact of debt investing that’s not commonly known is that corporate bonds usually have a minimum investment size. For example, an issuance may have a lot size of R50 crore. Smaller debt funds will, therefore, tend to have more concentrated portfolios adding to the risk. We recommend excluding funds that are small.
The portfolio for a fund does not remain constant and could change. So, it’s important to look at how the credit score of the fund changes over time. A good fund manager will maintain the blended credit score within an acceptable range over time. When that starts to change, it’s time to look for another fund.
Is it worth it?
Is it worth the trouble to invest in debt funds. The answer is: Yes. Debt funds provide a tax-efficient and liquid option for fixed-income investing. A little care and due diligence by you or your advisor will help you make the most of them.
The writer is chief executive officer, Scripbox