Why you shouldn’t Abandon Debt Funds? Don't Abandon Debt Funds (2024)

These are challenging times for debt funds investors. The stories of defaults and markdowns which began with IL&FS default have been tricking in very few weeks with DHFL being the last in this saga.

This has made a lot of existing and future investors jittery, and people seem to be losing confidence in debt funds. Some are even planning to abandon them entirely and move towards the safety of FDs.

But is this just hysteria or there is something wrong with debt funds? Well, read on to find out.

Why are so many debt funds in trouble?

In debt funds, your investments are not affected by equity market volatility. That’s because these funds invest in a range of interest-bearing instruments such as treasury bills, government securities, corporate bonds, and other debt securities.

Since government securities carry zero-risk of capital loss, they pay a lower interest rate. The issue is — if fund managers invest in them, they would have a difficult time to beat the returns from a fixed deposit, and no one would invest in their funds. That’s why debt funds invest in corporate debt papers, which to earn higher interest, but that comes with risk too.

Apart from the interest income, debt funds also buy and sell these instruments to generate returns. If due to some reason either of these two returns generating streams gets affected, debt funds are in trouble and that’s what happened.

Both IL&FS and DHFL didn’t honor their obligation of interest payment to lenders (mutual funds are one of them) with IL&FS even not able to pay back the principal amount, thereby ‘defaulting.’

This default meant the fund houses had to markdown all their investments in these company’s debt papers. A markdown means you are provisioning for a loss of the money lent plus future interest income. And since NAV of a fund is based on the value of underlying securities, a markdown brings down the NAV.

So when debt funds marked down IL&FS holding, NAVs fell from anywhere between 3 to 5 percent, wiping a year’s returns in a single day.

But this is not the first time defaults and downgrades have happened. In the past, Amtek Auto, Jindal Steel & Power, Ballarpur Industries and more have hit debt funds too.

Then why this sudden panic?

Investor’s perception worsens the situation.

Over the past few years, dropping bank deposit rates made people look at debt funds as an alternative to keep earning that 8-8.5% return they are used to.

Most of these people thought of debt funds are risk-free, which isn’t correct. Any product which strives to give you the above-mentioned returns will carry some risk, including debt funds.

So, what are these risks debt funds carry? Well, there are two kinds – Credit Risk and Interest Rate Risk.

Let us understand them and how you can minimize them.

• Interest Rate Risk:

Debt funds lend to corporates by buying bonds issued by them. The funds then buy and sell these bonds in the market. This buying and selling, as we mentioned at the start, also helps them generate returns.

The price of bonds gets affected by the interest rate movements in the economy, and this is what is called an interest rate risk.

Here is an example – If a debt fund bought a bond which gives its a 7% interest till maturity in-line with interest rate by RBI.

Now, if RBI decides to increase interest rates, the new bonds being issued by borrowers will give higher returns, and the demand for this lower interest rate bond will fall. This low demand will bring down its price and ultimately, the returns of the fund.

The inverse is also true. If interest rates get cut, this bond will have high demand, and the price will go up, which will mean higher returns.

It is tough even for experts to predict how interest rates will move. So, the best way to mitigate this risk is to invest in fund categories that lend for the low-to-medium duration because interest rates don’t change drastically in a short time span

• Credit Risk:

The risk of the borrower not paying the interest and/or the principal amount to the debt fund is what is known as Credit Risk.

In the case of IL&FS and DHFL, this risk played out. The borrower’s businesses faced difficulties, and they couldn’t pay the lenders.

The best way to keep this avoid this risk is to invest in debt funds that lend to highly rated corporates as part of their investment strategy.

You can find out the quality of the borrower of a fund by looking at ratings assigned to them by credit rating agencies. This rating indicates the general ability of the borrower to pay interest and the principal amount of the loan on time.

For example, CRISIL, one of India’s biggest rating agencies, gives a rating in the range of AAA and D, with AAA indicating lowest credit risk while D (Default) is when a default has happened or expected to happen soon.

One thing to remember is that since highly rated borrowers are low risk, they also give low-interest rates.

A quick guide for picking the right debt fund

Now that you are aware of the risks do make sure you go for a debt fund that matches your risk appetite and investment horizon.

Here is a quick table to help you achieve that with ease.

You can use liquid and ultra-short duration funds for longer investment durations too if you don’t want to take any risk. The difference in returns between these and slightly higher risk category funds isn’t too much and therefore, you will only make a substantial difference only when you invest a big amount.

Bottomline –

Debt Mutual Funds give you a chance to earn equivalent or better returns than bank deposits. This combined with the liquidity and more favorable taxation (if held for the right duration) makes them a smart option for non-equity investments

So, don’t abandon them. Just know the risks, pick the fund that matches your risk appetite and you won’t get any nasty surprises