Unusual times call for unusual fiscal and monetary policy measures. But the “whatever it takes” approach of policymakers to tackle the pandemic-related uncertainties has negatively affected the return potential of fixed deposits.

Investors who are conservative and bank on fixed deposits for interest income have been the most affected. They have distanced themselves from debt mutual funds too —thanks to the liquidity crisis following the IL&FS episode and the Franklin Templeton fiasco, which crushed investors with unforeseen losses and proved to be a sentiment dampener.

That being said, relying entirely on fixed deposits (and Small Saving Schemes) is not a very prudent approach even for conservative investors. The real returns (also known as inflation-adjusted returns) earned on bank fixed deposits and Small Saving Schemes is barely anything, and in some cases even negative. The highest interest rate offered by some of the top banks for a tenure up to 10 years for a deposit below Rs 2 crore is 5.75% (offered by Axis Bank).

On the other hand, certain debt mutual funds have generated decent market-linked returns albeit exposure to interest rate risk, credit risk, and other macroeconomic risks compared to other fixed-income instruments.

Table 1: How have various debt fund categories fared across timeframes?

Category Returns
(Absolute %) CAGR (%)
3 Months 6 Months 1 Year 2 Years 3 Years 5 Years 7 Years
Medium Duration 10.5 13.1 13.6 8.0 6.3 6.3 7.5
Low Duration 7.5 8.6 11.0 7.0 5.2 6.0 6.8
Corporate Bond 6.3 7.5 10.0 9.1 8.6 7.5 8.2
Credit Risk Fund 3.8 5.7 7.5 4.8 3.8 4.7 7.3
Short Duration 2.2 3.3 5.8 7.3 7.1 6.8 7.7
Floating Rate 1.1 2.5 4.9 7.2 7.8 7.4 7.9
Dynamic Bond 2.0 3.1 4.4 7.5 8.3 7.0 8.2
Banking and PSU Fund 1.1 2.3 4.3 7.4 8.6 7.6 8.1
Ultra Short Duration 1.1 2.2 4.2 5.1 6.0 6.3 7.1
Short & Mid Term 1.7 2.5 4.0 7.9 9.7 7.6 9.0
Money Market 0.9 1.9 3.7 5.1 6.4 6.5 7.1
Overnight Fund 0.8 1.6 3.1 3.4 4.2 4.9 5.7
Gilt Fund with 10 year constant duration 1.4 1.8 3.0 8.0 10.5 8.6 9.4
Liquid 0.7 1.5 2.9 3.7 4.6 5.4 6.4
Medium to Long Duration 2.1 3.1 2.9 7.6 8.3 6.7 7.9
Long Duration 2.9 1.4 2.7 7.7 10.5 7.9 9.1
Crisil Composite Bond Fund Index 1.8 2.4 4.0 8.2 9.7 7.5 8.6
Crisil 10 Yr Gilt Index 0.6 0.1 2.1 5.7 8.2 5.8 7.4
Crisil Liquid Fund Index 0.9 1.8 3.6 4.2 5.2 5.9 6.5

Data for overnight funds is as of November 14, 2021, while for all other categories as of November 12, 2021
(Source: ACE MF, PersonalFN Research) 

Relatively stable yields on the medium-term securities, those with a residual maturity of 3-4 years, have boosted the performance of Medium Duration Funds. Recovery witnessed in the segregated portfolios aided the 1-year return; nevertheless, it also highlights the risk they are exposed to. Among the Medium Duration Funds, schemes such as IDFC Bond Fund – Medium Term Plan and SBI Magnum Medium Duration Fund have generated respectable returns of over 9%-10% for the level of risk taken.

Over longer periods (3 years and more), the Long Duration Debt Funds, Gilt Funds, have fared well aided by the previous policy rate cuts by the Reserve Bank of India (RBI). Between February 2019 and now, the RBI has reduced the policy rates by 250 basis points. And since August last year, while the policy rates remained unchanged, the RBI continues to follow an accommodative monetary policy stance to support growth as long as it is necessary amidst the pandemic.

But bear in mind that we are very close to the end of the current interest rate cycle. Overall it appears that the present interest rate cycle has bottomed out. The risk to the inflation trajectory is emanating from higher oil prices, shortage of key industrial components, elevated metal prices, and high logistics costs. In such a scenario, the longer end of the yield curve could be more sensitive than the shorter end. Plus, the returns may moderate on the longer end of the yield curve. In other words, debt funds with longer maturity papers may not be able to generate attractive returns as seen in the last few years.

The Banking and PSU Funds sub-category, mandated to invest a minimum of 80% of its assets in debt instruments of banks, Public Sector Undertakings, and Public Financial Institutions, has generated consistent and respectable returns of over 8.5% compounded annualised for investors over the 3-year period. Schemes such as Axis Banking & PSU Debt FundIDFC Banking & PSU Debt Fund, and Edelweiss Banking and PSU Debt Fund, amongst others, have not only managed to generate superior returns as compared to bank FDs but exposed investors to a lesser degree of risk. This is because the underlying portfolio of Banking & PSU Debt Funds mainly comprises of quasi-government securities and public sector banks, along with some allocation to instruments issued by private banks and NBFCs. These companies enjoy high credit ratings (AAA or equivalent) and government backing, which makes them highly liquid and less prone to credit risk when compared to their peers in the corporate bond funds category.

Corporate Bond funds and Credit Risk Funds have fared well too. Aditya Birla Sun Life Corporate Bond FundDSP Corporate Bond Fund, and Sundaram Corporate Bond Fund featured among the top performers on 3-year returns with over 8%-9% compounded annualized returns. Similarly, ICICI Prudential Credit Risk FundHDFC Credit Risk Debt Fund, and Kotak Credit Risk Fund have managed to generate decent CAGR returns in the range of 8%-9% over 3 years with respectable portfolio characteristics.

A sharp recovery in economic growth has helped corporate improve their balance sheets. This is quite evident from the improving credit ratio, where in the first six months of the FY22, rating agency CRISIL upgraded 488 entities and downgraded only 165-a credit ratio of 2.96 times. The credit ratio is currently much better compared to 0.54 times in H1FY21 and 1.33 times in H2FY21. With India’s GDP expected to grow at 9.5% in FY22 and stable asset quality, this ratio is likely to improve going forward.

However, the excess liquidity and record-low borrowing rates depressed the return on Liquid Funds, Money Market Funds, and Overnight Funds. As you may know, the RBI under Mr Shaktikanta Das injected massive liquidity worth Rs 13 trillion into the banking system to avert any fallout of the COVID-19 pandemic-related distress on the financial system. The RBI has ensured that the systemic liquidity conditions remain very comfortable with a series of conventional and unconventional measures. Going forward too, liquidity conditions are expected to remain comfortable.

Debt mutual funds are alternative to fixed deposits if you wish to earn better market-linked returns albeit some risk. But keep in mind that investing in debt funds is not risk-free or safe. A prudent approach is necessary when investing in debt mutual funds.

How should you approach investing in debt funds?

Whichever sub-category of debt mutual funds you choose for wealth preservation (as per your risk profile and investment horizon), take care to select the best debt mutual fund scheme that can stand the test of time. Evaluate debt mutual fund on following parameters:

  • Returns across time periods (3 months, 6 months, 1 year, 2 years, 3 years)
  • Performance across interest rate cycles
  • The average maturity, Yield-To-Maturity (YTM), and the Modified Duration (MD) of the portfolio
  • The credit quality of instruments held in the portfolio.
  • The risk ratio (Standard Deviation, Sharpe Ratio, Sortino Ratio, etc.)
  • The Assets Under Management (AUM) and the expense ratio of the scheme
  • The experience of the fund manager, the number of schemes he/she manages (Fund Manager-to-Schemes ratio)
  • The overall investment processes and systems at the mutual fund house and its ideologies

In the evaluation process, you should be concerned if the mutual fund house lacks a robust risk management framework, depends excessively on ratings assigned by credit rating agencies; if the fund manager compromises on the quality of the portfolio, chases yields, and plays down on the liquidity aspects of the portfolio.

As a cautious and sensible investor, refrain from investing in schemes where the debt fund manager engages in undue yield hunting. What should be of paramount importance to you is the safety of capital (your hard-earned money). Besides, make it point to invest in congruence with your investment time horizon and risk appetite.

At present, given that the interest rates are at a multi-year low, the interest rate risk will be higher for funds having their major allocation to medium / longer-maturity instruments, including Gilt funds. To address a financial goal that is less than 3 years away, consider deploying your hard-earned money in Banking & PSU Debt Funds keeping an investment horizon of around 2-3 years. Note that Banking & PSU Debt Funds with a shorter portfolio duration of 1-3 years may be better placed to take advantage of the accrual opportunities, earn from coupon pay-outs, and help survive if the interest rates begin to rise.

For a short investment time horizon of less than a year, consider investing in the best Liquid Funds. Typically, Liquid Funds invest in Treasury Bills, Commercial Papers, Call Money, Certificates of Deposits, and so on. This helps them keep interest rate risk to a minimum. However, make sure to invest in a pure Liquid Fund, i.e. the Liquid Fund should not have exposure to private debt papers. Remember, the returns are secondary when you invest in a liquid fund. The main objective is to keep your hard-earned money secure but highly liquid, and hence you should prefer safety over returns.

Note that along with capital appreciation, wealth preservation is also an important investment objective. Following a practical and astute investment strategy, plus your investment discipline will pave the path to your financial success.

This article first appeared on PersonalFN here

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