It isn’t just the equity-fund investors who are facing the unrelenting heat, due to the global selloff, the last few weeks have been difficult for investors in debt funds as well.

The latest AMFI data for the month of March shows that debt mutual funds witnessed outflow of Rs 1.95 trillion. Of this, a major chunk of Rs 1.10 trillion belonged to liquid fund, followed by ultra-short duration funds, money market funds, and low duration funds, and short duration funds.

Outflows were also seen in banking and PSU funds, credit risk funds and corporate bond funds.

Overnight funds, long duration funds, and gilt funds were the only category that saw positive flows.

AMFI Chief NS Venkatesh has attributed the decline in the debt side to quarter end phenomena when banks have to maintain capital adequacy norms and corporates have to fulfil advance tax obligations. Banks and corporates generally park their funds used to fulfil these obligations in debt funds. These funds usually come back at the beginning of the next quarter.

But this time, since redemptions in March have been higher than previous quarter end in the FY 2019-20, there could be more to it than just quarter end obligations.

Graph: Debt funds witness massive outflows in March 2020

Data as of March 31, 2020
(Source: AMFI, PersonalFN Research)

Liquid funds which saw the most outflows in March have been facing redemption pressure since the past few months. As I had mentioned in my article published in February, investors have shown a shift in preference from liquid to overnight funds after SEBI introduced the graded exit load on liquid funds if redeemed within seven days. Owing to this step, inflows in liquid funds could continue to decline in coming months as well.

Moreover, FPIs turned net sellers in Indian debt market in March due to high volatility and uncertainty caused by the outbreak of covid-19 pandemic. As the pandemic poses a threat to the world, developing economies such as India could be hit hard. This has made investors turn to safer havens such as gold and dollar denominated bonds.

Some categories of debt funds have been dealing with a spate of defaults and rating downgrades over the last one year. With business operations across sectors severely affected due to lockdown imposed by the government to curb the spread of virus, credit risk of corporates, especially those with high leverage could heighten. Banks and NBFCs with exposure to such corporates fear rising risk of non-performing assets. This could be another reason for debt investors cashing out.

Given the current circumstances, I believe that inflows in debt funds could be muted in the coming months as well.

However, on a brighter note, the RBI and government have been taking measures to support economic growth and maintain liquidity. This could provide some relief to investors in debt funds.

What should debt mutual fund investors do?

The interest rate scenario could continue to be volatile in the near term. Government borrowings, fiscal deficit, inflation, and FPI activity could put upward pressure on interest rates. On the other hand, RBI’s measures to infuse liquidity, rate cuts and removal of restriction on FPI investment in government securities could soften the yields. Furthermore, the potential impact of the pandemic on the economy cannot be ascertained at this time.

These factors may create lot of uncertainties in the interest rate movement.

Thus, you may consider sticking to shorter duration funds such as short-term, ultra-short term, liquid, and overnight funds that are less likely to be affected by interest rate movement. Additionally, these funds carry lower credit risk.

However, if you are willing to take extra risk, consider allocating a portion of your portfolio in dynamic bond fund to ride the interest rate movement on the either end of the yield curve.

But ensure that you select debt funds carefully. In the past, some fund houses have proved to be habitual risk takers, taking investors for granted. The latest example being the Yes Bank crisis, where some shorter duration funds had exposed its investors to higher risk.

So when in doubt, prefer the safety of principal over returns. Choose debt mutual funds where the fund house has a robust investment process and risk management strategy in place and where the fund manager does not chase returns by taking higher credit risk.

This article first appeared on PersonalFN here