Debt Mutual Fund investments: What are the Myth versus Reality

Jul 21, 2018 / Dwaipayan Bose | 88 Downloaded | 5948 Viewed | |
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Despite growing investor awareness and popularity of mutual funds in India, investor interest in debt mutual funds is still lukewarm in the retail segment. In fact, most retail investors in India normally associate mutual funds with equity investments and risk perceptions are thereby shaped by such association. Mutual funds offer a vast array of fixed income investment options through debt mutual funds. The vast majority of average household savings is in fixed income assets (e.g. savings bank accounts, FDs, Government Small Savings Schemes etc).

As per a recent report, excluding Maharashtra and National Capital Region (NCR), which have large presence of institutional investors, equity mutual fund assets under management (AUM) in India is less than 7% of bank deposits. Debt mutual funds have historically given superior returns than bank deposits, but a number of misconceptions about these mutual funds have prevented investors from getting superior returns on a large part of their savings. In this article, we will discuss some common myths about debt mutual funds.

But before we start, let us read why you should not ignore debt mutual funds

MYTH 1: Debt mutual funds give low returns and have high risks

Reality:

Debt mutual funds invest in debt market securities like Government Securities (G-Secs) and Non-Convertible Debentures (NCD). They also invest in money market instruments like Commercial Papers, Certificate of Deposits and Treasury Bills etc. The risk of debt and money market securities is much lower than stocks (equity market). For example, while the stock market gave negative returns in bear market years like 2008, 2011 and 2015 / 16, short term debt mutual funds gave positive returns in the same years. The risks of equity and debt as asset classes are simply not comparable – debt mutual funds are much less risky than equity mutual funds.

Risks and returns are directly related. Since debt mutual funds are less risky than equity mutual funds, it is only to be expected that they will give lower returns than equity mutual funds. One cannot expect debt mutual funds to give 15 – 20% returns like equity mutual funds – top performing debt mutual funds usually give high single digit returns over a 2 to 3 year period, although in certain favorable interest environments, they have also given low double digit returns. For similar tenures, debt mutual funds have outperformed bank deposits (savings and term deposits) most of time.

Did you know credit opportunities funds can give higher returns with limited volatility

MYTH 2: Fixed Deposits are risk free and give higher returns than debt mutual funds

Reality:

It is true that Fixed Deposits are risk-free and give assured returns. Debt mutual funds on the other hand are subject to market risks. However, it is this very reason which causes debt mutual funds to give superior returns than Fixed Deposits. Simple logic dictates that risk free rate of return should be the lowest rate in the economy, yet many investors do not get this logic, their thinking perhaps being clouded by risk aversion or misinformed opinions of others. Debt mutual fund returns are closely linked with bond market yields. Why would a bank offer to pay high rate of interest and increase their costs, if bond market yields are low? In order to maximize profits, banks will always want to offer lowest possible interest rates.

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If you look at the history of bank FD rates of different tenors, you will see that the bank FD rates were almost always lower than Government bond yields of similar tenors. Top performing short term debt mutual funds have outperformed bank FDs in 7 out of the last 10 years. Long term debt mutual funds are more volatile, but they have also outperformed bank FDs over 3 years plus investment tenures taking advantage of higher yields and interest rate changes.

Corporate bonds (NCDs) pay higher interest (coupon) rate than G-Secs of similar tenors – if they paid lower interest rate than G-Secs, then why will anyone invest in NCDs because G-Secs are risk-free. We discussed earlier that Bank FD rates are almost always lower than G-Secs of similar tenor; by extension, FD rates are even lower than NCD yields. It is true that NCDs have credit risk but good debt mutual funds mostly invest in NCDs of the highest credit qualities, thereby earning much yields (around 2% more than bank FDs over the last few years) while minimizing credit risks.

Finally, debt mutual funds are much more tax efficient than bank FDs. Interest paid by bank FDs are taxed as per the income tax rate of the investors. Long term capital gains in debt mutual funds are taxed at 20% after allowing for indexation benefits; indexation benefits reduces the tax obligations of the investors considerably. In summary, while FDs are risk-free, investing in the right debt mutual funds can get investors superior tax free returns.

MYTH 3: Debt mutual funds are meant for institutional and corporate investors not retail

Reality:

It is true that institutional investors account for the vast majority of debt mutual fund assets under management (AUM) in the industry. However, this is simply a fact and one should not draw any conclusion from this –the low retail percentage is actually indicative of the lack of awareness of debt funds among retail investors. It is not as if, institutional and corporate investors have higher risk appetite than retail investors. A large amount of corporate assets in debt MFs is for working capital purposes and companies cannot afford to take risks with liquidity as far as working capital is concerned.

Institutional investors want to deploy their funds as efficiently as possible – should not retail investors aspire to do the same? In fact, the considerations which drive institutional investments in debt mutual funds, viz. liquidity, risk, higher profits and tax efficiency should be the same for retail investments in fixed income. The only difference is that institutional investors have more knowledge and exercise more rational judgement in investment decisions. Lack of awareness should not be hindrance in getting the maximum bang for your buck. Your financial advisor can work with you, to help you make better investment decisions.

Please read – are you risk averse: understand your risk capacity

MYTH 4: All debt funds are same

Reality:

The risk profiles of different types (categories) of debt funds are more sharply differentiated than different categories of equity mutual funds. All equity mutual funds are subject to stock market risks – mid and small cap equity mutual funds are usually more volatile than large cap equity mutual funds, but the nature of risk is same. In the debt mutual funds, there are two types of risks, interest rate risk and credit risk. Different categories of debt mutual funds, depending on the nature of underlying securities have very different sensitivities to these risks.

Long term debt mutual funds are highly sensitive to interest rate changes. Dynamic bond funds are also quite sensitive to interest rate changes because the fund managers take duration calls. Short term debt mutual funds have limited to moderate sensitivity to interest rate changes. Money market mutual funds like liquid and ultra-short term debt mutual funds have very limited sensitivity to interest rate changes. Debt mutual funds which invest heavily in G-Secs have limited credit risks. Gilt funds which invest only in G-Secs have no credit risks. On the other hand, corporate bond funds are exposed to credit risks.Investors should clearly understand the risk characteristics of a fund before investing.

Why do not you read – Should you invest in long term debt mutual funds or avoid it

Myth 5: Best to invest in funds which have given highest returns

Reality:

As discussed earlier, different types of debt mutual funds have different risk characteristics. A fund which gave high returns in a particular interest rate scenario, may not give the best returns in a different scenario. Interest rate scenario may change from year to year or every 2 to 3 years. Therefore, one should not speculate. You should invest on the basis of your investment goal, tenor and risk appetite – instead of investing in the fund which gave best returns, invest in the fund which is right for you.

You may find this useful – why long term debt mutual funds are underperforming short term funds

Debt mutual funds offer a large array of products which can cater to variety of investment tenors, risk appetites and interest rate scenarios. As per SEBI’s categorization guidelines, there will be 16 categories of debt mutual funds, each with its own risk characteristics – the categorization process is underway and will soon be completed by all Asset Management Companies (AMCs). Not all the 16 categories will be relevant for your investment needs, but one or two may be perfectly suited for your specific needs – your financial advisor will be able to help you identify the right funds.

Conclusion

In this article, we discussed some common myths related to debt mutual funds among retail investors in India. Do not let these misconceptions hold you back from availing the benefits from these wonderful investment products. It is true that debt mutual funds are more complex to understand compared to equity mutual funds. This is where your financial advisor can help. Call your financial advisor to know more about debt mutual funds and if they are suited for your investment needs.

Read: how to selected best mutual funds: lessons from football

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.

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