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Understanding debt mutual funds

Over the past few weeks, there have been some concerns over debt mutual funds, especially after default by IL&FS and potential concerns over the bonds of a few other instruments. Some of these issues, both in recent times and in the past, have been fringe factors causing unnecessary noise.

Over the past few weeks, there have been some concerns over debt mutual funds, especially after default by IL&FS and potential concerns over the bonds of a few other instruments. Some of these issues, both in recent times and in the past, have been fringe factors causing unnecessary noise. 

The fact is, debt funds have added excellent value for investors over the past 20 years and will add excellent value well into the future. Share of debt funds, as a proportion of the overall banking industry will keep gaining. Its benefits, which are listed below, will continue into the future.

  • Higher returns than bank savings
  • Daily liquidity
  • Tax efficient

Good logical investors base their investment decisions around logical reasoning & data, rather than fear. With this note, we hope to help you understand debt mutual funds better.

1. Purpose:

  • The main purpose of debt mutual funds is to channel an investor’s savings efficiently to borrowers. Take the case of a liquid fund for example. At present (based on the last few months performance), a liquid fund has given an annualized rate of 7.4% to investors. A typical liquid fund charges a fee of 0.15-0.2% per annum and therefore investing in instruments yielding about 7.6% pa. The 5 year government bond yield is about 7.5% now. 
  • A bank also channels investor’s savings to borrowers, but the economics is vastly different. A typical large bank borrows at a blended average rate of 5.1% (includes current account at 0%, savings bank at 4% and Fixed Deposit at 7.2%) and lends to investors at a blended average rate of 8.7%, having a total spread 3.5% of which its costs are about 2.1% and rest of the spread, 1.4%, is its profits. 
  • As you would have noticed, liquid funds deliver investor’s savings to end borrowers at the lowest cost. Over time, such funds will channelize a significantly larger proportion of an investor’s savings to borrowers, as they are just a very efficient channel.

2. Risks :

Credit Risk

  • The first and foremost risk is what we call ‘Credit Risk’ – i.e, if a debt mutual fund invests in a bond of a company which defaults. The good news is that a significant majority of debt fund’s investments are in government bonds or AAA paper. AAA instruments are considered very high on credit rating and that too with a large share of Public Sector Units like Indian Oil, NTPC, etc.
  • The following table shows the spread of instruments collectively held by all debt mutual funds and you would notice a vast majority are in instruments which are safe. The ‘Others category’ in the table below included BBB paper or below and cash. Essentially, what this table suggests is that debt funds, collectively are quite safe.  
  • Typically, the larger liquid and low duration funds hardly hold any low quality instruments. Much of these are with corporate bond funds or high yielding funds.

  • Banks also carry similar credit risk in their lending and given the current state of the balance sheets of banks, nearly 10% of lending by banks are to companies which have already defaulted. At a collective level, the lending books of debt funds are far better than the lending books of banks. On the other hand, there seems to be an implicit government guarantee on all deposits by banks. 

Interest rate risk

  • Interest rate risk is a bit more complex subject. Here’s a somewhat simple explanation.

Say you invest in a 1 year bank FD at 5% today, which means that if you invest Rs 100 today, you will get Rs 105 at the end of 12 months. Assume the FD is locked-in and you have to necessarily stay with the FD.

Say, due to certain reasons interest rate shot up to 10% in a day and you go back to the bank the next day to create an FD. In that case, when you invest Rs 100, you will get Rs 110 at the end of 12 months. Since the first FD is locked-in, you have to necessarily hold it. Clearly, the 2nd FD (100 going to 110), is better than the first FD (100 going to 105).

Therefore, though both FD’s invested value is 100, the 2nd FD is of higher value than the first FD OR  the 1st FD’s value diminishes in value when interest rate rises. This principal is called interest rate risk. 

  • A debt mutual fund needs to show the current market value of its debt investments, whereas a bank need not show that for your Fixed Deposit.
  • The following table shows how the 10 year government bond yields have been changing over the past couple of years. In general, as interest rate go up, debt funds with longer duration instruments lose out.

  • On the other hand liquid funds and low duration funds don’t see much volatility, when interest rates rises or falls. Whereas, high duration funds see lot of volatility.

What should I, as an investor do? : 

We do agree this is complex. To keep it simple, use the following principles while investing in debt funds and you should do fine.

  1. Stick with funds which invest mostly in AAA corporate or government bonds, and therefore minimise credit risk.
  2. Have minimal interest rate risk.
  3. Have minimal expense ratio.

You would also like to read best debt funds to invest in 2019

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