Debt funds are considered low-risk and stable investment instruments. But in February, several debt funds price witnessed acute falls. Some have continued to shed value over the next month. Some funds lost as much as 7-12% in a day while others were luckier to be hit only 1-2% in a month. A fall of this nature can easily erase gains accumulated by a typical debt fund over 2-3 months. What was the reason for the sudden crack in debt fund returns?
Let’s try and understand this incident, but first, let’s start with how a debt fund’s price can be influenced.
What impacts debt fund prices?
The price of debt fund is correlated to the prevailing interest rate. When the interest rate rises, the price of debt funds falls and vice versa. For example, if you own a debt instrument which pays interest at 9% and if the interest rate falls to 7%, your holding becomes of greater value to investors. But if the interest rate increases to 11%, your holding loses value.
Inflation also impacts debt fund prices indirectly. As inflation rises, so does the possibility of an interest rate hike, and so debt funds lose value.
Similarly, the change in credit ratings of the underlying instruments in which debt funds invest, also impacts its price to some extent. When the credit rating of bonds in which debt funds invest goes up, the interest rate of that bond falls and the debt funds with existing investments in that bond appreciate.
You may also watch:
What happened in February?
Debt-Oriented Mutual Funds: Absolute Return Between February 7-9, 2017.
The RBI monetary policy review happened in February. Some fund houses were hoping for a new cut in interest rates. The interest rate cycle also indicated it was close to a trend reversal. But some debt funds had invested heavily in debt instruments with a long maturity period, especially long term gilt and bonds. Due to high demand, there was appreciation in long-term gilt and bonds before the policy review. But when the RBI announced its decision to maintain rates, the prices of these instruments fell. Any fund that had invested in them thus incurred losses of varying degrees.
Additionally, some mutual funds also held debt and equity positions in certain firms whose financial position wasn’t strong and whose credit ratings fell recently. With the fall in equity returns combining with the fall in debt returns, any fund that had invested heavily in such firms lost big.
The question that everybody should ask here is this: should fund managers invest in anticipation? Is it a regular practice or a special case where the investor has incurred losses due to such transactions?
Fund managers invest your money only after a thorough analysis of all macro-economic factors. The same position had been taken by several fund managers across fund houses. There is competition among fund houses that want to offer the best possible returns to their investors. This leads them to sometimes take higher risks to provide higher returns. Sometimes, these decisions don’t work out, and that’s what happened this time. But when things pan out as per the expectations of fund managers, investors reap profits.
You may also watch:
As for February, fund managers could have taken a conservative approach by anticipating the both a rate change and no change scenario. It would have softened the impact of what eventually followed.
At this point of time, when investors have already suffered losses due to the events of February, the best step they could take is to stay invested and keep a strict watch on the debt market volatility.
If you are looking to make fresh investments, then short term or liquid fund could be better options than debt funds with huge exposure in long-term gilt. Also, use the SIP route to ride over short-term volatility.
(The writer is CEO, BankBazaar.com)