Why you cannot afford to ignore Debt Funds

Sep 11, 2023
 

In an interaction with a chief investment officer at a mutual fund, I was given some advice that every investor should specifically remember in bull markets.

"You won’t lose money investing in a liquid fund or an overnight fund. Even in other debt funds such as floating rate, ultra-short term, medium term, and dynamic bond fund, the chances of losing money are slim."

Why is this important? Let me explain.

Debt is a capital protection tool, NOT a return tool.

The aim of an investor is NOT to always make big money, it is also to protect what you have. It is to provide a buffer to the portfolio, a safety net of sorts. The returns will be low or moderate, but capital protection is the dominant factor.

Yes, there could be wealth erosion due to the impact of inflation, but at least capital erosion is being protected.

There is no denying the need for more growth assets, but it must be balanced with sufficient assets invested in fixed income to provide that buffer to the portfolio.

Debt is NOT dispensable.

Debt serves as risk-reducing ballast in a portfolio. That must be the focus when one is investing in debt, and its purpose does not change, irrespective of the state of the equity market or the low yields of fixed income instruments.

Never look at a portfolio only from one dimension. A portfolio is more than a collection of holdings. The key consideration when constructing a portfolio is how the holdings work together to help you reach your financial goals. This is far more important than the return of any single holding.

Capital preservation and capital growth have to be viewed in conjunction. A portfolio must be constructed with both goal posts in mind.

During certain phases, one asset class may appear dispensable. Don’t fall for that narrative. In a rampant bull market, you may question why you are invested in debt. In a brutal bear, you may want to flee equity altogether. Don’t act on your impulses.

The bedrock of a portfolio is suitable asset allocation. The asset classes must complement the other, not compete with them. To draw an analogy, the 64 black-and-white squares on a chessboard complement each other and give structure to the layout. Each occupies a different position and serves a purpose. A chess board must have both.

In an environment of rising inflation, debt acts as a drag on returns. Think of it as ‘portfolio insurance’. Insurance is a cost you pay to provide you with a return in the event of a particular outcome. It provides protection during an equity market crash. It serves the role of a shock absorber and takes the edge off in periods when equities are volatile or falling.

Debt is NOT to be blindly invested in.

Depending on a host of factors, you will have to arrive at your own equity and debt allocation. You then work within that framework. Younger investors who have a long-time horizon for their investments don't have a need for a big allocation to debt. But the closer you get to your goal date, especially retirement, the more you need to consider debt.

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.

All debt funds are certainly 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.

Debt is NOT a homogenous category.

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).

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. For example, 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 doesn’t mean that every single investment needs to have this maturity limit. It is about the portfolio average. So the average maturity can be misleading as there’s a big gap between actual maturity/liquidity and what it seems to be at the category level.

Also check the credit rating of the invested paper.

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