Debt Mutual Funds – 7 Hidden Risks

Till few years back i was quite bullish on Debt Mutual Funds. The Great Crash of Debt Mutual Funds in July 2013 shattered my faith in Debt Mutual Funds. The most impacted funds were Liquid Mutual Funds that are considered to be safest among all. Liquid funds invest in money market instruments. The lower maturity period makes them best investment option for short term. I regained my faith in Debt Mutual Funds and invested in Long Term Debt Mutual Funds. The last one year is also not good, especially for long-term/gilt debt mutual funds. We will discuss this later in detail. The 1 month return of most of the 4 and 5 start funds are negative. The one-year post tax return is less than FD rates.

The fund managers or investment advisers always show returns of best performing funds. Not everyone is LUCKY in this regard. Let me share an example of ICICI Prudential Long Term Fund. Investors who invested a year back in this fund, the annualized returns were around 18% at that time. Today it is 9%. As i layman, if i checked the performances a year back and today, there is nothing wrong. But the investors fail to observe the downward slope. In short, investors who invested through SIP/lump sum during last one year must be seeing negative or very low returns. It is contrary to the fact that REPO Rate is cut by 1% or 100 basis point. Then what went wrong, i would like to ask galaxy of experts and investment advisers who suggested this fund a year back. I will answer this in point no 6 in the following section. My conclusion is that Debt Mutual Funds are as RISKY as Equity during a volatile time. The good time to invest in debt mutual funds and equity is only during stable markets.

Debt Mutual Funds – 7 Hidden Risks

1. Debt Means SAFE: The misconception of Debt means Safe is the biggest RISK for investors of debt mutual funds. Investors think that these funds cannot deliver negative returns that are not true. The one month return of all the long-term debt mutual funds & gilt funds is negative. Let me clarify that debt mutual funds means these products invest in debt instruments that may or may not be SAFE. The debt instruments are also volatile. Therefore, this misconception of debt means safe is a biggest hidden risk for the investor.

2. Bond yield and Repo Rate: The returns of debt funds are directly or indirectly linked to the Govt of India’s 10-year bond yield. The RISK is that bond yield may not drop with a decrease in REPO Rate. In last 1 year, RBI has cut REPO RATE by 100 basis point but the 10-year bond yield is flat. Though experts always expect the 10-year bond yield to move in tandem with REPO Rate. The 10-year bond yield on Jan 22, 2015, was 7.71 and today it is 7.72. In short, it is flat and range bound. To share an example how analysts went wrong. On Sep 29 RBI cut REPO Rate by 50 basis point, and bond yield dropped from 7.72 to 7.51 in 1 week. Now it is again back to 7.72. It explains why the 1-month return of debt funds is negative.

3. FII Investment: Not many people are aware that FII flow in debt markets is much more than investment in Equity Market. Recently, FII outflow spooked the equity market. God forbids if FII’s decide to exit debt markets then what will happen to debt markets. Unfortunately, FED is expected to raise interest rate in Dec. It might trigger FII outflow from Indian debt markets as well. In such a scenario, what will be the impact on returns of debt mutual funds?. God Knows.

4. Rating of Papers: The NAV of the two debt schemes of JP Morgan Mutual Fund collapsed due to exposure in NCD’s of Amtek Auto. The schemes were Short Term Income Fund and India Treasury Fund. Both schemes had exposure of 200 Cr in Amtek Auto. The NAV of ST Income fund collapsed by 3.4%. The fund has to write off the amount that caused this slide. To outperform each other, the debt funds invest in sub-standard papers. The lower the rating of a debt paper the better return it offers. In fact, credit opportunities debt funds invest in those papers that have a low credit rating of A or AA but there is a possibility of rating improvement in future. If there is rating upgrade, then returns are much superior.

5. Global/Domestic Factors: Global/Domestic factors also impact returns of debt mutual funds. For example, softening of crude prices or decision of a Fed in USA impacts the returns of debt funds. On the domestic front, the movement of rupee was a critical reason for the crash of debt markets on July 2013. All these factors are unpredictable and during volatility it is better to stay away from debt markets.

6. The market is ahead of times: Trust me Retail Investors enter when the PARTY is OVER both in Equity and Debt Markets. The market is always ahead of times and factor the good/news before the retail investors react. In the case of bond yield, it dropped from 9.10 to 7.85 i.e. by 125 basis point in 2014 before RBI’s 100 basis point cut in repo rate. In advance, the market factored in Repo Rate cut of 100 basis in 2015. Now during late 2014 and early 2015 all the experts, analysts and investment advisers started recommending long-term debt funds. Due to lack of knowledge, Retail Investors were trapped. I always suggest, please don’t listen to market experts and analysts.

7. Inflation: Inflation is quite unpredictable. It decides interest rate movement. From a double-digit inflation, we moved to negative inflation within a year’s time. Thanks to falling crude prices. The returns of debt mutual funds are linked to interest rate movement that in turn depends on inflation. High inflation means high-interest rates and vice versa.

Retail investors fail to judge the interest rate movement. The debt funds are of various types. Depending on investment objective, the debt fund reacts differently to increasing/decreasing interest rate. Theoretically, short-term debt funds deliver good returns during increasing interest rate. On the hand, during decreasing interest rate the long term debt funds provide good returns. Therefore, debt mutual funds require rejigging based on interest rate movement.

Words of Wisdom: There is a lot of volatility in both equity and debt markets. As i mention that markets are ahead of times. The bond yield is increasing as i shared earlier. Taking a cue, i anticipate market is factoring increase in inflation thus higher bond yields. I observed returns from short-term debt mutual funds improving. At the same time, global factors including Fed rate hike cannot be ruled out. In my post, Harsh Reality of Negative Mutual Funds, i mentioned that it is time to exit equity mutual funds. The same view i hold for debt mutual funds.

Now you must be wondering where to invest. I will disclose in my future post.

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