3 myths regarding debt funds

By Morningstar |  08-11-16 | 
 
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Often there is a lot of perception surrounding an investment avenue that takes unsuspecting investors down the wrong path. Debt funds too have beliefs that could be partly true at best and misleading at worst. Here we debunk three common misconceptions.

Myth I: Debt funds are risk-free

No market-related investment is risk free, be it equity or debt. While debt funds are not as perilous as equity funds, they are not without their share of risks.

The two prime risks in a debt instrument are the interest rate risk and credit risk.

The interest rate risk refers to a change in the price of a bond due to the change in the prevailing interest rate. As interest rates rise, bond prices fall and vice versa. The higher the maturity profile of a fund’s portfolio, the more prone it is to interest rate risk. So in a rising interest rate scenario, opt for funds with lower maturities. The reverse in a falling interest rate scenario.

Credit risk refers to the credit worthiness of the issuer of paper-- either a corporate or financial institution. Credit risk takes into account whether the bond issuer is able to make timely interest payments and repay the principal amount on maturity. A firm with a low credit rating often compensates investors by offering a higher return. So if the fund is delivering admirably, do check to see if the reason is due to a portfolio packed with relatively riskier instruments. Government bonds, incidentally, are sovereign backed and have the highest rating in terms of safety.

Moreover, if the fund manager invests in poorly rated paper, this could turn into a liquidity risk. A fund faces liquidity risk if the fund manager is not able to sell his paper due to lack of demand for that particular security. Liquidity risk is high in funds with a low credit quality portfolio.

Myth II: Debt funds will never give negative returns

This myth is all the more prevalent in the case of liquid funds. Investors actually believe that returns from a liquid fund can never be negative.

Since the instruments in such a portfolio have a maturity period of less than 91 days, the interest rate risk does not exist to the tune it does in other debt funds. Moreover, the fund managers tend to stick to a high credit rating to maintain a very high quality portfolio which makes it less susceptible to default risk. But not for a moment are we suggesting that they are risk-free.

Let’s recap what happened in July 2013. The net asset values of liquid funds showed a negative return over a short period taking everyone by surprise.

The Reserve Bank of India intervened very aggressively in the market to curb currency speculation and halt the slide of the rupee. The fallout was rising short-term rates and a tight liquidity position which made liquid funds lose out on mark-to-market valuations. Such funds had to make accounting of returns on mark-to-market basis in the case of all papers with a residual maturity of 60 days and above. A sharp increase in overnight rates led to a fall in bond prices leading to the loss in valuation. As a result, the NAV of liquid funds dropped. Though it spooked investors, the drop was marginal. For instance, between July 15 and 16, the drop in NAV of liquid funds was a maximum 0.34%. This was a one-off event that did not last long. But investors should take heed that such instances can occur.

As Martin Leibowitz,  co-author of "Inside the Yield Book, was once quoted in Wall Street Journal saying: “Bonds are thought of as a safe haven, but even the safest harbors have waves”.

Myth III: Debt funds are only for institutions

Debt funds are a good way for investors to balance their overall investment portfolio. However aggressive an investor’s portfolio, an allocation to debt is always advisable, even if it is miniscule. Debt funds are a great avenue to help an investor diversify his portfolio into a different asset class.

Related to this is another myth that an investor would need huge amounts of money to invest in a debt fund. This would be true for investors buying debt instruments directly from the secondary market. However, if investing in a mutual fund, a big ticket size is not needed. Investors can invest in a debt fund with as little as Rs 1,000.

If you need to park your cash for just a few months, there are ultra-short term or liquid funds to look at. Short-term funds are for those who would like to invest for a period ranging from one to three years. For periods beyond, there are intermediate and long-term debt funds.

Also read: 3 basic terms regarding debt investments

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