Do you need debt funds in a portfolio?

By Morningstar |  09-04-21 | 

While constructing any investment portfolio, there are three core objectives on every investor’s mind: protect capital, beat inflation and create wealth. Here is what you should keep in mind when constructing a portfolio.

Do you need debt?

Few may opt for an all-equity portfolio to achieve their goals, with some even opting for a concentrated portfolio of a dozen stocks. However, an asset allocation (equity and debt) based approach is ideal for portfolio construction, since it aims to strike a balance between stability and growth.

Equity and fixed-income asset classes are inherently different in terms of their risk-return profile. Equities have the potential to deliver superior inflation-adjusted returns compared to fixed-income over the long term. They are the most favoured asset class for wealth generation over the long term, and should form a part of an investor’s portfolio subject to his/her risk appetite.

When compared with other fixed-rate instruments such as fixed deposits or small savings or bonds, equity is more volatile. The returns are not assured. And there is even the possibility of loss of invested capital. However, over longer time horizons, equities tend to outperform most asset classes with diminishing probability of capital loss.

While equity fulfills the role of wealth creation, fixed-income offers stability to the portfolio. The returns on offer for fixed-income instruments are dependent on factors such as the inflation estimate over the investment horizon, the real returns offered, and the credit, maturity and illiquidity risk premiums.

The asset allocation mix should be a function of the risk appetite of the investor. Longer the investment horizon and greater the risk appetite, higher can be the allocation to equities.

Don’t fall for false narratives such as ‘debt funds are like FDs’. They are not.

If you are an ultra-conservative saver who really doesn’t want to take any risks, stick with bank fixed deposits. The assurance you get from it will not be available with a market-linked product.

Of course, there is the existential risk to the bank itself. But if you stick with the systematically important and too-big-to-fail larger banks, you are on solid ground. If you are not ultra conservative, then debt funds must not be ignored from a portfolio standpoint. However, be cognizant of the inherent risks in debt mutual funds such as interest rate risk, credit risk and liquidity risk which can subject the portfolio to significant drawdowns.

Banks deposits are fixed-return products with no interest rate and credit risk, and the return is guaranteed at the time of investment. On the contrary, mutual funds are marked-to-market products and are hence impacted by changes in interest rates and credit spreads. For example, the sharp fall in interest rates particularly in short-term rates following various measures by the central bank to mitigate the slowdown in the economy, helped most debt mutual funds deliver double-digit returns in past few calendar years.

From a taxation perspective, interest from fixed deposits is taxed annually at the marginal tax rate. The interest you earn is added to your income and taxed depending on the slab you fall under.

When it comes to debt mutual fund, there are short-term capital gains (STCG) for a holding period of up to 36 months, and long-term capital gains (LTCG) for periods above 3 years. STCG is taxed at the marginal tax rate only at exit, just like a bank deposit. LTCG is taxed at 20% post indexation.

Most of the shorter-duration mutual funds do not levy any exit load/penalty on withdrawal, unlike bank deposits which levy a penalty on early withdrawal.

The focus of debt funds should NOT be return on capital, but return of capital.

Debt funds are primarily for capital preservation. To add alpha to your portfolio and beat inflation, there is equity.

So why debt funds at all? Because the return is higher than that of a fixed deposit. The interest earned on a fixed deposit is added to your income and taxed in the income bracket that you fall under. Post the taxation, the return does not even beat inflation. If a fixed deposit returns 8-9% post-tax returns, who would want a debt fund with its risks? But reality is that bank deposits return much less, and when you take into account inflation and tax, it is even more dismal.

Opt for debt funds over fixed deposits because of the higher overall return, but don’t focus on optimizing returns to the point of ignoring risks. Capital protection must get your disproportionate attention.

Credit risks are completely avoidable over the short and medium term. It won’t change portfolio returns dramatically on the upside but the risk taken will increase manifold. As for long-term goals, the credit risk should be capped to a small exposure as it can backfire at precisely the wrong times with no scope or time for recovery or course correction. And you wouldn’t want that kind of risk with your long-term goals.

So even though all debt funds have different degrees of interest risk and credit risk, give disproportionately high weightage to limit the credit risk.

Besides the slightly higher return than fixed deposits, an advantage of debt funds is that they provide an easier and more liquid route to rebalance the portfolio in both directions.

To maximize returns, you need to take risks. And if you need to take risks, do it via the equity component in your portfolio. Not debt.

Most investors want high returns irrespective of the asset they are investing in. When you see a fund delivering that extra return, check whether it is coming from additional credit risks embedded in the portfolio.

Within the shortlist of funds having low credit risk, preference should be for funds that have a conservative approach towards managing their debt portfolios and have a predictable style and clear thought process. Some other factors that should be considered are AUM of the fund (avoid very small ones), vintage (avoid unproven new ones), concentration risks within funds’ portfolio (to instruments as well as issuers or groups), expense trends, etc.

Most investors are unaware of how to assess the risks in debt funds. They are just unable to distinguish between interest rate risk (which is about returns being hampered) versus the credit risk (where the risk is about losing capital). Give a lot more weightage to controlling the credit risk, especially if you are a risk-averse investor.

High returns mask the risk being taken. So if a debt fund is delivering really high returns compared to its peers, it must be taking a risk that is playing out well for now. Always question the source of that out-performance.

All debt funds are NOT the same.

Another lesson that should be learned is that all debt funds are not the same. There are different debt fund categories. And even within a category, do not assume there is homogeneity. Open the bonnet of these funds and you will see that their engines have several unwanted components; hidden from investors who don’t bother to look.

Investors pick debt funds based on the categories. In a way, the category is used as a proxy of the riskiness of funds. But many times, the actual risk is very different due to the fund’s choice of bonds/papers even within the definition of the category.

Even though the category of a debt fund may be an indication of the average maturity profile of the fund, the actual bonds/papers held by the fund may be of a longer duration. So an ultra-short duration category will have 3-6 months average maturity profile. But it may hold bonds/papers that have a maturity of 1-2 years as well.

Why?

Because the category rule is about the average maturity and doesn’t mean each and every component needs to have this maturity limit. Only the portfolio average should be within the definition. So the average maturity can be really deceptive as there’s a big gap between actual maturity/liquidity and what it seems to be at the category level.

On a closing note…

Debt mutual funds are actively managed funds that invest into a variety of instruments such as a corporate bond, non-convertible debenture (NCD), government security (G-sec), state development loan (SDL), treasury bill ((T-bill), commercial paper (CP) and certificate of deposit (CD).

While selecting funds, one should consider the investment horizon. For very short tenors, say up to 3-6 months, one can consider investing into liquid or ultra-short term funds which have very low interest and credit risk involved. For relatively longer tenors, one can decide to invest into shorter-term categories (such as low-duration, short duration, banking & PSU) to longer duration categories (such as long-duration funds and 10-year constant maturity gilt funds) with some amount of interest rate and/or credit risk depending on risk appetite.

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GUNESH APTE
Apr 15 2021 06:15 PM
 One advantage of investing in Debt Funds which some articles do not highlight is its flexibility to allow an investor to invest and redeem funds, based on your needs.

For equity-debt asset balancing or as & when you save some money, you may need to invest it in Debt Fund. This may not be easy in Fixed Deposits, where partial withdrawals are generally allowed but adding more money in the same FD after some days/months is not easily allowed. You may have to create multiple FDs and track them.

Some banks do have flexibility to add top ups in Recurring FD, but it is limited to some amount.

Also, Fixed Deposits in some banks could be risky similar to debt funds, due to high NPA(s) of that Bank.

If one invests only in Gilt Funds of shorter/moderate/longer durations, at least credit risk is avoided. Though Interest Rate risk remains, but one can navigate through this risk by holding the funds for longer durations.

So, there are Pros and Cons of Fixed Deposits as well as Debt Funds.

One need to select the Debt Product based on individual requirements, and risk appetite.
ninan joseph
Apr 10 2021 06:53 PM
 I agree with the author. The only exception being

Debt funds are primarily for capital preservation. To add alpha to your portfolio and beat inflation, there is equity.

I think, this sentence was not correctly worded. Investors invest in debt fund to get an alpha over FD rates and to have their capital protected. If it was only to preserve capital, we will go for FD. The expectation from debt fund is to have capital protected and get an alpha over FD rates.

I think the body of the article articulates the same, maybe I am interpreting it wrong.

Fully agree with the author.
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