2017 was a great year for the stock market and mutual funds. As per December 2017 AMFI data, industry wide assets under management in equity and balanced funds rose 77% year on year. Even after factoring in value appreciation due to market rally, this show a lot of fresh money has flowed into mutual funds in 2017. This is great news for the mutual fund industry and its various stakeholders; the efforts which the Asset Management Companies and more importantly, mutual fund distributors in different cities and smaller towns across India, put on investor education for the past several years is paying off now.
However, one financial advisor based in Kolkata, expressed his concerns about certain aspects of this growth to me a few weeks back. His concern was related primarily to senior citizen investors. With lower fixed deposit (FD) and Government small savings interest rates, this advisor is getting calls from many senior citizens who want to invest their FD maturity amounts in balanced funds in the hope of getting higher income through dividends. The advisor is worrying that, the next bear market, whenever it comes, may cause a lot of capital erosion and financial stress for senior citizens, who shift the asset allocation from debt to equity. The advisor’s concern is valid because the risk profiles of debt and equity asset classes are very different; equity is a much riskier asset class compared to debt and investors should understand the risks associated with equity before investing.
I told the advisor that FDs and equity or balanced funds are not like to like comparison; he should recommend debt or debt oriented hybrid mutual funds to investors with low risk appetite, especially senior citizens who want to shift their corpus from FDs and small savings schemes to mutual funds. The problem with debt funds, the advisor said was that, investors and even many financial advisors do not have a good understanding of debt mutual funds. Debt fund is a vast and slightly complicated topic. Unlike equity funds, there are many debt fund product categories with their specific risk characteristics.
One of the questions that we often get from investors is which debt fund is suitable for them. There are broadly three types of debt funds – money market mutual funds, short term debt funds and long term debt funds (there are also many sub-categories which are outside the scope for the purposes of this blog post).
Read how to select debt funds by understating the risk
Money market mutual funds like liquid funds and ultra-short term debt funds are very low risk investments, suitable for investment tenure of less than 1 year. For investment tenure of more than one year, investors should consider short term debt funds or long term debt funds. This is where many investors get confused because returns of short term debt funds and long term debt funds can vary a lot from year to year depending on the interest rate environment.
In this two part blog post, we will discuss how short term and long term debt funds work, particularly with reference to debt fund performance in 2017. In the second part of this post, we will discuss which type of debt fund might be suitable for your investment needs.
Before we discuss about short term and long term debt funds, let us recap how debt funds performed in 2017. 2017 was a bad year for debt funds and many investors are likely to be disappointed with their debt fund performance. However, investors should know that 2017 was an exceptional year for bond markets; investors got excellent returns from debt funds just the year before. The chart below shows the average returns of different debt fund categories in 2016 and 2017.
Source: Advisorkhoj Research
You can see that, short term debt funds and long term debt funds disappointed in 2017; returns were lower than FD interest rate. However, if you combine the returns of 2016 and 2017, both these debt fund categories would have beaten FD interest rates over the last 2 years. This is the reality of market linked investments; you have to be prepared for variability in performance.
Let us discuss why short term and long term debt funds underperformed by understanding the basics of bond investing. Bond investors get returns from two sources:-
Bond prices are inversely related to interest rates. Some investors have asked me, why bond prices fall even if RBI keeps the interest rate (repo rate) unchanged. While repo rate is an important interest rate for the economy, bond prices depend on demand and supply situation. If the demand for debt is higher than supply, the borrower has to pay more returns to the lender. In the case of bond issuers, higher returns can be realized by paying a higher coupon (interest rate) or by simply reducing the price of the bond (for the same coupon / interest). Return for bond investors for a particular price is known as yield. When yields go up, bond prices fall. This benefits new bond investors, but hurts existing bond investors because they invested in the bond at a higher price. Let us now discuss the difference between short term debt fund and long term debt fund.
Let us now discuss why short term debt funds underperformed in 2017. The chart below shows the yields trajectory of 2 year Government Bonds in 2017; short term debt funds invest in bonds which mature in 2 – 3 years.
You can see that the yields have been steadily rising from July 2017. Yields have increased almost 50 basis points in the last 5 months; even on a yearly basis bond yields rose almost 50 bps in 2017. For a bond of 2 – 3 year duration, a 50 bps rise in yield can mean a price decline of 1 to 1.5%. So if a bond was paying an annual interest rate (coupon) of 7%, the return of bond in the last 1 year would be 5.5 to 6% only. This explains the underperformance of short term debt funds versus FDs in 2017.
Let us now understand why long term debt funds underperformed even more in 2017. Long term debt funds invest in longer maturity bonds, which are more sensitive to yield changes. The chart below shows the yields trajectory of 10 year Government Bonds in 2017.
You can see that the 10 year Government Bond yields rose almost 100 basis points or 1% in the last 5 months; even on a yearly basis yields rose 1% in 2017. For a bond of 10 year duration, a 1% rise in yield can result in 10% decline in bond prices. So even if a 10 year bond was paying 9% interest rate (coupon), the 1 year returns would be negative. Investors should note that, long term debt funds invest at different points in the maturity spectrum (mix of long term and medium term bonds); that is why they were able to generate positive returns, even though long term bond yields rose substantially.
In the interest of all our readers, a discussion on the macro factors that led to depressed bond market and rising yields in 2017 is outside the scope of this blog post. Investor knowledge aside (we have discussed the various factors which affected bond market in a separate post), 2018 might be a very different year for bonds compared to 2017 because higher bond yields may attract foreign investors to Indian bonds. Let us now discuss some misconceptions regarding long term and short term debt funds.
Before we start talking about the misconceptions regarding debt funds, what about knowing debt mutual funds and their various types
You may like to read this as well – How to select debt funds: modified duration and volatility
In the first part of this two part blog post, we discussed how debt funds performed in 2017, the difference between short term debt funds and long term debt funds, and tried to explain the relative performances of these two debt fund categories in 2017. We also clarified some misconceptions regarding these two types of debt funds. In the next part of this blog post, we will discuss how to choose between short term and long term debt funds.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Sundaram Asset Management Company is the investment manager to Sundaram Mutual Fund. Founded 1996, Sundaram Mutual is a fully owned subsidiary of one of India's oldest NBFCs - Sundaram Finance Limited.
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