Should the debt mutual funds be part of your portfolio?

The need of the debt asset class in the investment life cycle of a person is important. Initially, when income and total net worth of an investor is less, the debt investment primarily happens through PF and PPF (debt cum retirement schemes). Overt time, the net worth of a person grows with more investible surplus available for investment in debt for a diversified portfolio. As a person comes closer to achieving financial milestones such as kid’s higher education and marriage, he needs ready money; again, he relies on the debt asset class. During retirement, a person becomes more conservative and majority of his asset are invested in debt asset class to avoid any surprise.

Bottom line, traditionally, the debt asset class has been the mainstay in the investment portfolio in financial life cycle of an individual. Lately, in the debt asset class, the debt mutual fund (debt fund) is becoming the product of choice as it is designed to diversify the portfolio reducing risk and generating superior post tax return compared to bank fixed deposits.

What is Debt Mutual Fund?

The debt mutual fund invest in securities such as Treasury bills, Government Securities, Corporate Bonds, Money Market instruments and Debt instrument of Bank and PSUs. The return from debt fund is in terms of interest income and capital appreciation of the underlying securities.

SEBI recently came out with the directive on categorization of debt mutual funds, according to which the funds are categorized based on maturity duration (i.e. from overnight to 7 plus year)

The credit rating of debt securities are issued by the independent rating agencies such as CARE, CRISIL and ICRA, which is one of the key input for investor’s investment decision.

What are some of the challenges faced by debt funds in recent years?

Since 2015, the credit rating downgrade and default of few credible companies such as Amtek Auto, Jindal Steel & Power, Ballarpur Industries, has resulted in instant reduction of debt fund value.

IL&FS is a recent addition. IL&FS is India’s largest infrastructure financier and developer backed by LIC, SBI, ORIX corp. from Japan and Abu Dhabi Investment Authority.

IL&FS has issued massive debt with short-term maturity but the return from the invested infrastructure projects is expected only in long term. This has created a cash flow mismatch and resulted in its inability to pay to its bonds and commercial papers holders.

This resulted in credit rating downgrade of IL&FS from “high grade” to “junk” by rating agencies. Approximately 25 debt mutual funds (primarily liquid and short-term debt funds) have about Rs. 2700 crore worth of exposure through commercial papers and NCDs of IL&FS. These funds have marked down their investment resulting in fund’s NAV decrease.

Why did it happen?

When it comes to the credit rating, the Credit Rating agencies have struggled to highlight the rating degrade of companies over a period. At the same time, AMCs have become solely dependent on input from credit rating agencies to identify the credit worthiness of the issuers and have not focussed on their own due diligence. In addition, some of the AMCs have taken concentrated position in securities with higher risk beyond their mandate of liquid, ultrashort duration and low duration funds. These low rated securities have poor liquidity and make it difficult for investors to come out in the time of crisis.

What is the way forward for you?

While in recent history, we have seen few cases of credit defaults on securities, they are far and few between and for a diversified debt fund holding these securities, the impact is minimal.

It is very important for you to do your own due diligence and pick the funds whose fund managers are not in hurry to beat the benchmark and peers’ performance. You should consider the fund houses, which have rigour and a process in place to comply with the stated mandate and look for better return only in the long run. The debt funds are still the best conservative, liquid investment options with better return than the bank fixed deposits.

Listed below are high-level guidelines, which you should apply for your debt fund investments.

• Identify the percentage of investment you would like to do in debt mutual funds
• Invest in debt funds, which match your risk profile and investment tenure e.g. for lesser risk, you should consider liquid, money market or short duration debt funds; If you are investing in credit risk funds, be mentally prepared for volatile return in the short term.
• Pick funds from the fund houses with proven debt investment strategy and management
• Avoid debt funds with concentrated exposure to single security
• If you have to choose a fund with higher yield or lower risk, tilt towards later
• Use this product in combination with other debt investment options to create an optimized debt strategy

A recently conducted survey in a social media group on the ownership of the debt mutual funds came out with a startling finding that 50% of them they do not own debt mutual funds.

Debt fund is an important investment option as part of the debt strategy and overall portfolio as there are many situations in which usage of debt fund makes portfolio smart. It is important that people seriously consider this option for their investment journey but stay vigilant and cautious.

The writer is a SEBI Registered Adviser and Founder of FinMyn (https://finmyn.com). He provides Fee-Only Financial Planning and Investment Advisory services. If you want to know more about him, click on https://finmyn.com/about/.