Should You Invest in Debt Mutual Funds in the Current Scenario?

Many saw debt mutual funds as a suitable alternative when banks slashed their deposit rates by a huge margin. But, what they did not see coming was that the debt mutual fund segment was itself under a crisis.

The winding-up of six debt mutual funds under various categories of Franklin Templeton has opened the pandora box. How fund managers go overboard to chase returns and compromise on the credit rating of the portfolio and falling down.

The combined asset value of all six Franklin Templeton debt funds which were closed is around Rs 30,852 crores (as on March 31, 2020), which is quite huge. And, investors are now stuck, not able to withdraw from the schemes. Surely, it affected the credibility of the sector.

Therefore, in such a scenario should you be investing in debt mutual funds now?

My answer is not completely to avoid the debt mutual fund category but go for funds having good credit quality and with lower duration to lower the risk. Let’s check in detail.

Investing in Debt Mutual Funds

You should know that all debt mutual funds are not unsafe and it is important that you know the inside out of the debt mutual fund before investing. You should understand how interest rate change, credit quality of the portfolio affect the value of your fund.

And, you should not just measure the fund’s performance through its returns.

How to Analyse the Performance of Debt Mutual Funds

Why should you be concerned about the duration of a fund?

You should know that duration of the debt fund has a direct correlation with the return of the fund. 

The duration of the fund, also known as modified duration expresses the measurable change in the value of a security for a per cent change in interest rate.

For example, if the modified duration of the fund is 4.22 years, then a per cent increase in interest rate would decrease the value of the fund by 4.22% and vice versa.

This metric is useful when you have an investment horizon of 3 years or more. You should always aim for funds having low modified duration. It helps in reducing the volatility and offers a predictable return graph.

Why should you always check the credit quality of the fund?

What Franklin Templeton did was investing in low-grade and illiquid debt papers to get higher returns. It stayed invested in debt papers of companies like Reliance ADAG, Yes Bank, Voda-Idea, which has witnessed multiple rating downgrades. Similarly, one of its funds has exposure to the securities having a credit rating of “A” and below and that constitutes 28% of the portfolio against a category average of 3%.

This investing strategy was doomed from the beginning itself and was like a ticking time-bomb in the current situation.

Therefore, always check the credit risk rating of the portfolio. The fund’s portfolio should consist of over 90% AAA-rated and sovereign guaranteed securities.

What type of debt funds should you consider right now?

Choosing the right type of debt fund is a must in the current scenario. With RBI continuing to be in an accommodative stance, which means it is open to further rate cuts to revive the economy, investing in debt funds with a long term horizon can be a little tricky.

Funds having a longer modified duration are more prone to losses if the interest rates shoot up due to inflationary pressure. And, given the huge liquidity in the system and fiscal deficit of both centre and state, it might lead to an inflationary situation, which can result in a sharp increase in interest rates.

In such a scenario, investing in funds with a duration of 3 years or less is more suitable as they are less sensitive to interest rate change. Following are the fund category with low duration:

  • Ultra-short duration funds having a modified duration of around 6 months
  • Low duration funds having modified duration in the range of 6-12 months
  • Short duration funds having modified duration in the range of 1-3 years
  • And, medium duration funds having modified duration in the range of 3-4 years

Funds under medium duration funds are more suitable when interest rates are likely to remain constant.

Other debt mutual fund categories are liquid fund, floating-rate fund and banking & PSU fund are known liquidity and funds with lowest credit risk ratings.

Checklist for Investing in Debt Mutual Fund

Check whether the fund suits your investment objective

Your investment horizon and risk appetite should match the duration of the fund and credit risk rating of the fund to get the optimum result. For example, if your investment horizon is of 1 year, then the fund’s duration should be less than one year having a credit risk profile of low-to-moderate risk rating. 

Understand the credit risk profile of the fund’s portfolio

It is important to understand the credit risk profile and check whether it aligns with your risk appetite. For example, debt funds having 65% of their assets in AA or below rated securities are suitable for investors with moderate to high-risk appetite. 

Also, check the yield curve of the fund because it is directly proportional to the credit-risk of the fund. Funds that offer higher yield or YTM particularly invest in low-rated debt papers that carry higher credit risk.

Final Words

Investing in debt mutual funds is not like investing in any fixed income products as they carry significant risk. And, if not understood or managed properly, your investment can give negative returns. 

In the current scenario, investing in funds having high-rated debt securities in its portfolio with low duration is most preferable. They are least sensitive to interest rate and liquidity risk. 

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