In our previous post, How to select the right debt funds for your portfolio – Part 1, we discussed how to select the right debt funds based on your investment tenure. There is a relationship between investment tenures and risk preferences. Shorter the investment tenure, lower is the risk expectation. However, even for the same investment tenures different investors may have different risk preferences and return expectations. In this post we will discuss, how you can select debt funds based on your risk / return expectations.
Risk appetite, in this context, is the need for capital safety versus higher returns. For some investors capital safety is of the highest importance, even at the cost of returns. For example, Rakesh has accumulated funds for making the down payment for property purchase. He has begun the search process and he has short-listed some properties. It may take him a few weeks or a few months to finalize the property, negotiate the price, get a loan and complete the purchase.
Where should he invest his funds for making down payment? For Rakesh, capital safety and liquidity are of the highest concern because his main goal is to buy the property; the return he gets from his accumulated funds for a few weeks or months is simply extra income. Rakesh should therefore, invest his accumulated funds in a very safe and highly liquid debt fund. Rakesh invests his money in a liquid fund.
Let us now discuss a situation, where returns are important. Ramesh has been saving for his daughter’s college education through systematic investment plan (SIP) in a diversified equity fund. Three years before his daughter goes to college, Ramesh decides that he cannot expose his savings for daughter’s education to the vagaries of the stock market; a severe bear market can easily wipe off a big portion of Ramesh’s accumulated investment. So Ramesh switches from equity to fixed income. While capital safety is important for Ramesh as well, he wants to get good returns also. He has three years till his daughter goes to college and the more money he can accumulate, the more he can spend for his daughter. Therefore, Ramesh is willing to accept some short term volatility in order to get higher income from this investment. Ramesh invests his money in a long term debt or income fund.
Let us spend a few minutes understanding the fundamental nature of risk in fixed income investing. There are basically three kinds of risk in fixed income.
Let us now discuss how we can avoid these risks. Interest rate risk can be avoided by holding bonds till maturity (as explained in our post, How to select the right debt funds for your portfolio – Part 1). Credit risk can be avoided by investing in Government Securities or highly rated (AAA, AA etc.) corporate bonds. Re-investing risk can be avoided by matching your investment tenure with the bond maturity or in the case of debt funds, the average maturity. You must remember however, that risk and return are related. If you want to avoid risks, you will be giving up on returns.
Let us now understand interest rate risk from the perspective of a long term income fund investor. Debt fund investors should know that, income funds (or long term debt funds) are subject to interest rate risks. In the last three years, income funds gave an average nearly double digit returns (please see our research tool, Mutual Fund Category Monitor). You can argue that, in the last three years we had a benign interest rate regime. But what about the last 5 years?
In the last 5 years, we also have periods of rising interest rates. In the last 5 years, income funds gave an average 9% returns (please see our research tool, Mutual Fund Category Monitor). You may say that, what if I do not have a 5 year holding period? The lowest 3 year annualized rolling return of average income fund category over the last 5 years was 7.3%. This was the worst case scenario for average income funds in the last 5 years for investors with a 3 year holding period.
This is still better on a post tax basis for investors in the highest tax bracket, than the best FD interest rate over a three year period, given the tax advantage of debt mutual funds over fixed deposits. By the way, the best 3 year annualized rolling return of average income fund over the last 5 years was nearly 12%.
Why are income funds able to give good returns over a long period? The answer is simple. Over a long period of time, interest rates do not move in unidirectional manner. A period of rising rates will inevitably be followed by a period of falling rates. Smart investors, who are able to invest at the peak of the interest rate cycle, will benefit the most from income, but over a sufficiently long period of time, most investors can benefit from good income funds, irrespective of when they invested. Continued to Part 3
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
We understand what you're working for
We are committed towards helping individuals, businesses & institutional clients achieve financial security & success.
Would you like to continue with some arbitrary task?
Would you like to continue with some arbitrary task?
Send this article to the following email id.