Investors should look at various risks of investing in debt funds as Kotak AMC was unable to pay the entire redemption amount in some of its FMPs.
By Arvind Chari
Recent events involving delay and deferment of redemption proceeds of fixed maturity plans (FMPs) of some fund houses due to the apparent delay in payments by Essel Group companies has reignited the issue of risks in debt funds. The credit crisis in the bond markets which began in September 2018 is not over yet and investors should prioritise safety and liquidity over returns while investing in debt funds. Keep in mind the following tenets when investing in debt funds:
Debt funds are not wealth generating products. They are meant to provide returns similar to that of bank deposits, subject to market risks and in some cases have better taxability over fixed deposits. They are not bank fixed deposits and even FMPs are not bank fixed deposits. Returns from a debt fund, including FMPs, are not guaranteed under any circumstance.
Market risks: Change in NAV due to change in prices of bonds it holds is very frequently as market interest rates change based on change in macro environment.
Credit risks: Fall in NAV due to deteriorating financials of the firm in which the fund is invested will see credit rating downgrades which will result in higher bond yields and lower bond prices.
Default risks: Fall in NAV due to non-payment of interest or principal by companies such as ILFS and its subsidiaries.
Liquidity risks: Inability of the fund to sell its investments and meet redemptions of investors due to poor market conditions.
Debt funds may need longer holding periods in order to play out a cycle and benefit from long-term capital gains taxation. Debt funds are classified into four categories: liquid and money market, short term, dynamic/long term, credit risk funds.
Liquid funds: Low market risks, but as events of the last four years suggests, it can have credit and default risks. Liquid funds/money market funds are meant to invest your short-term cash surplus. Do not take credit risks trying to earn higher returns in this segment. Choose liquid funds which avoid credit risks.
Short-term bond funds: Higher market risks than liquid and money market funds. This segment is considered as an alternative to one to three-year fixed deposits. Evaluate between them, especially on the extent of credit risks the fund carries in its portfolio. FMPs tend to be in the one to three-year category. But they are close-ended and investors have to remain fully invested till maturity. FMP portfolios tend to be concentrated and hence should be closely evaluated on credit risks.
Long term/ dynamic bond funds: High market risks and is the segment where distinction between the aspect of fixed income and volatility in the NAV and returns is difficult to understand. Bond funds often have periods of low and/or negative returns and hence investors may need to hold it for a longer period for the interest rate cycle to play out.
(The writer is head, Fixed Income & Alternatives, Quantum Advisors)