While investment in equity mutual funds has the potential of generating high returns, its performance can suffer during phases of high market volatility. Investing in debt mutual funds provides the much-needed stability to your investment portfolio especially during uncertain and volatile market environment. Hence, debt funds are an important avenue from a diversification standpoint which should form a part of every investor’s portfolio.

Do remember that though debt funds carry lower risk as compared to equity investment, we cannot assume it to be risk-free.

You may recall that in the last couple of years various debt funds have been hit by a spate of defaults and rating downgrades in its underlying securities. As a result, NAV of these schemes took a knock and investors had to suffer losses.

The heavy redemption pressure amid the pandemic crisis came as another blow for the debt fund segment. Struggling to meet the heightened redemption demand Franklin Templeton in April 2020 shut six of its debt mutual fund schemes overnight. The investors in these schemes are now left in a lurch, hoping to get their money back.

How debt funds are expected to perform in 2021

Since the outbreak of the COVID-19 pandemic, the RBI has reduced policy rates by 115 basis points (bps). And from February 2019 until now, the reduction in policy rates is good 250 bps with the accommodative stance taken since June 2019 to address growth concerns. With this, the interest rates have reached multi-year lows.

Table: Series of policy rate cuts in 2019-20 to address growth concerns

Month Repo Policy
Policy rate
cut (Basis points)
Monetary Policy
Feb-19 6.25% 25 Neutral
Apr-19 6.00% 25 Neutral
Jun-19 5.75% 25 Accommodative
Aug-19 5.40% 35 Accommodative
Oct-19 5.15% 25 Accommodative
Dec-19 5.15% Status quo Accommodative
Feb-20 5.15% Status quo Accommodative
Mar-20 (an exceptional off cycle meeting) 4.40% 75 Accommodative
May-20 (an exceptional 2nd off cycle meeting) 4.00% 40 Accommodative
Aug-20 4.00% Status quo Accommodative
Oct-20 4.00% Status quo Accommodative
Dec-20 4.00% Status quo Accommodative
Total 250

Data as of December 04, 2020
(Source: RBI)

Bond prices and interest rates are inversely related; so when interest rates fall, bond prices rise. Since long term bonds are more sensitive to interest rate movement as compared to short term papers, NAVs of these funds have risen in the last couple of years. This is why long duration funds have generated attractive double-digit returns amid rate cut.

However, going forward, it would be imprudent to expect similar returns from long duration funds.

With economic activities slowly getting back on track and arrival of the COVID-19 vaccine, there is a possibility that the current interest rate cycle has bottomed out. Thus, the returns may moderate on the longer end of the yield curve and could turn riskier (may encounter high volatility) in the foreseeable future.

Currently, the shorter end of the yield curve looks more attractive than the longer end. You’ll be better off deploying your hard-earned money in shorter duration debt mutual funds such as liquid fund and overnight fund. And if the investment time horizon is over a year, you may consider Banking & PSU Debt Funds that allocates 85-90% of its assets in instruments issued by major Banks and PSUs.

You can also consider investing dynamic bond funds that have the flexibility to change the portfolio duration according to changes in the interest rate scenario.

Things to keep in mind while selecting debt funds for investment

As mentioned earlier, debt funds have witnessed various credit events in the past which lead to erosion in the wealth of investors. It can take a long while for a scheme to fully recover from any setback caused by defaults and downgrades. So, when you invest in debt funds, focus on the safety of capital instead of chasing returns.

[Read: Lessons Learnt from the Debt Fund Crisis]

Avoid schemes (including short duration schemes) that have high exposure (over 20%) in instruments issued by private issuers, irrespective of ratings assigned by other rating agencies; it can expose the portfolio to credit risk. Even though fund managers have remarkably reduced their holding in low-rated securities in the aftermath of the Franklin Templeton crisis, many schemes across debt fund categories still carry significant allocation to moderate and low rated assets.

Notably, while the debt market situation has improved significantly post the pandemic-induced liquidity crisis and market regulator SEBI has taken various steps to make debt fund investment safe, it still important to be cautious.

Therefore, to avoid taking any undue risk, invest in schemes that predominantly invest in instruments issued by government and public sector enterprises. These securities are generally high quality as the government-backing ensures enough liquidity and low credit risk.

Before investing in debt funds understand the various risks involved viz. credit risk, duration risk, interest-rate risk, liquidity risk, etc. and invest in schemes where the portfolio risk aligns with your own risk appetite and financial objective.

In addition pay attention to the following parameters:

  • The portfolio characteristics of the debt schemes;
  • The average maturity profile;
  • The corpus & expense ratio of the scheme;
  • The rolling returns;
  • The risk ratios;
  • The interest rate cycle; and
  • The investment processes & systems at the fund house

Alternatively, if you prefer to keep your capital safe, opt for bank fixed deposits, but there as well, choose the bank carefully.

This article first appeared on PersonalFN here

Leave a Reply

Your email address will not be published. Required fields are marked *