Debt Funds: How to Think Correctly ‘First’ – [Important]

When you board a flight, generally the thoughts about turbulence aren’t on mind. But when your flight does pass through turbulent weather, then you feel stressed. And rightly so.

I am also 100% sure that at some point during the turbulence, you would hope (and pray) that you are in a super reliable and strong plane, being flown by a skillful and trustworthy pilot who isn’t very adventurous.

Right?

And that is exactly how debt funds should be chosen.

Think about it. If you were told that the pilot will be taking some undue risks just to reach the destination a few minutes earlier, you may not want to board that ‘fast by 10-15 minutes’ flight and risk your life.

The same should be the case when investing in debt funds.

I wanted to share my thoughts about debt funds in general. I was recently quoted by Morningstar about How Investment Advisers pick Debt Funds (or use the link here).

So I thought I will elaborate on the thought and write a slightly detailed note. Don’t worry. This post isn’t about the technicalities of debt funds, but rather about how to think correctly about debt funds. Once you are able to think prudently about debt funds, only then you will be able to pick the right debt funds for your portfolio.

Before I even begin, let me say that if you are an ultra-conservative saver who really doesn’t want to take any risks, then don’t invest in debt funds. Stick with the traditional bank deposits (FD). They are not bad as many would have told you and indeed are a decent option for conservative savers, even though they get taxed heavily. Of course a new risk you would face is the existential risks to the banks themselves. But if you stick with the systematically important and too-big-to-fail larger banks, then you and your FDs will remain fine.

For all others, debt funds are worthy of consideration.

And if you wish to properly manage your long-term personal finances and financial goals, then debt funds shouldn’t be ignored.

There have been tons of attempts to recast debt funds as this and that and what not. Some of those attempts are genuinely correct. But many others aren’t. Don’t fall for the false narratives like ‘debt funds are like FDs’ and ‘debt funds are risk-free.’ These are incorrect no matter who told you what. Debt funds have their own set of risks embedded in them and (for the record), aren’t risk-free.

So it’s better to make some effort to understand these risks so that you can pick the right debt funds for your future investments.

With that said, let’s move on.

Think about it – Why do you even think about investing in debt funds?

Because you want higher than the risk-free rate of return.

If the bank FDs were giving post-tax 8-9% returns, then you wouldn’t even want debt funds to be there. Why take unnecessary risks when safe FDs are good enough. But these are not 80s and 90s and the FDs don’t give that much.

So if you wish to generate a higher than the risk-free rate of return, then you need to take some risks. And that is fair and that is how it should be. In other words, you should be compensated (with potentially higher returns) if you take additional risks.

And this is the whole concept of debt funds.

Debt funds ‘can’ generate better post-tax returns than bank deposits and similar instruments. It’s not a guarantee but mostly valid. But there are risks to this too.

I have a fairly simple thought process when it comes to debt funds and debt in general.

On the debt side of investments, I have a strong bias for prioritizing return OF capital over return ON capital. Debt is primarily for capital preservation. As for the returns and beating inflation, I prefer the other volatile animal named equity.

Having said that, if you are willing to take risks then no doubt it is possible to generate additional 1-2% returns in debt funds as well. But for that, you would have to take incrementally very large, unnecessary and often unknown risks. And these risks just don’t justify the small gains of an additional 1-2%. It’s like increasing your driving speed from 60kmph to 65kmph but in turn, also increases the risk of an accident by 75%.

You may differ with me on this. But that’s fine. We can all have different opinions.

Remember and I say this at the cost of sounding repetitive: Debt is the safe side of any investor’s overall portfolio. So focus should be to optimize returns without taking huge risks. In fact, capital protection should get your disproportionate attention.

Taking credit risks should be a complete avoid for the short & medium-term goals. It won’t change portfolio returns dramatically on the upside but the risk taken will increase manifold.

Even for the longer-term goals, the credit risk should be capped to a small exposure as it can backfire at precisely the wrong times with no scope or time for recovery or course correction. And you wouldn’t want that kind of risk with your long term goals. So even though all debt funds have different degrees of interest risk and credit risk, I give disproportionately high weightage to limit the credit risk.

In fact for ultra long-term goals like retirement where safer alternatives like EPF, VPF, PPF are available, efforts should be made to first exhaust them before introducing debt funds. Of course, debt funds provide an easier and more liquid route to rebalance the portfolio in both directions. So it’s no doubt a good option and has to become a part of the larger portfolios that have reached the upper limits on PF contributions.

What else?

Within the shortlist of funds having low credit risk, preference should be for funds that have a conservative approach towards managing their debt portfolios and have a predictable style and clear thought process. Some other factors that should be considered are AUM of the fund (avoid very small ones), vintage (avoid unproven new ones), concentration risks within funds’ portfolio (to instruments as well as issuers or groups), expense trends, etc.

And please, don’t get into hero worship of fund managers and invest in a debt fund that a cowboy is managing. You never know when the underlying risks will jump up and punch you and the fund manager in the face.

Most debt funds investors (and MF sellers too) are unaware of how to assess the risks in debt funds. They are just unable to distinguish between interest rate risk which is about returns being hampered versus the credit risk where the risk is about losing capital. So when it comes to debt, any day you should give more weightage to controlling the credit risk. And especially, if you are a risk-averse investor.

Some people mailed me and asked about Credit Risk Funds and their relevance.

Hmm…

I have never understood the reason to take high risk in debt. And credit funds are built on the high-risk premise itself. So Credit Risk funds as a category has always been a clear avoid for me. The new clients who come on board with legacy exposures to these are also advised to exit it in an efficient manner unless of course it’s relevant to their risk profile and as long as allocation isn’t materially large.

But mostly, it’s best to avoid this category. Not worth taking that degree of risk in debt.

Now our respected regulator SEBI did its bit by creating a separate category for these credit risk funds to help in clear identification. And that was a good move made as part of the entire mutual fund categorization and rationalization exercise in 2018.

But somehow, there were/are still funds in other categories that carry enhanced ‘credit risks’ without it being reflected in the category name.

How?

The fund managers use workarounds around SEBI’s definition to deliberately expose themselves to high credit risks to generate additional returns. They then generate higher returns than their peers for a year or two in favorable market conditions. Many who pick even debt funds based on the return wise top funds of the category get attracted. These unsuspecting investors who don’t understand that the source of high returns is unwanted, high-risk behaviour of these fund managers that can backfire in unfavorable markets.

The high returns mask the risk being taken. And to be fair, no one is bothered. Human nature. People don’t ask questions if they are getting high returns. They just get attracted to high returns like iron gets attracted to a magnet and bees to flowers.

But if a debt fund is delivering really high returns compared to what its category peers are managing, then you need to understand something – someone is taking a risk that is playing out well for now. But whether it will continue to play out well continuously or not is very important to be found out.

I tweeted this a while back (here) and sharing as relevant to the discussion:

Some funds (equity / debt) may consistently perform well. But the source of their out-performance (i.e. good returns) may be a strategy / style which is too risky. And hence, those funds may not be suitable for everyone, despite good returns. Most don’t want to understand this.

Unfortunately, some fund houses and MF distributors had been positioning a few credit risk funds as an alternative to fixed deposits. In fact, I have come across instances where people told me that even credit risk funds were sold as no-so-risky funds. Why? Maybe because of incentives and high commissions. Conflict of interest at play. Who knows? This was really unfair on their parts and I feel sorry for small investors who were impacted by this behaviour.

SEBI really should seriously look into how to control the narrative for riskier products as clearly, the current product labeling or fund categorization haven’t been enough.

And beyond a doubt, the recent crisis and closure of few debt funds (written about it in detail here and here) has been an eye-opener for investors as well as those advising/handling clients as well. I too have learned a few things.

And the incident of fund wind-down has aggravated investors’ worries about the debt funds and have them question their faith in debt funds as an investment category. But this wasn’t a bolt out of the blue. The stress was building in the system and there were indications.

And please don’t misunderstand me. Debt funds are still a good investment vehicle. I have my money invested in a few as well.

But as they say, learning gets accelerated in not-so-good times.

So maybe, it is a good time for the investors to relearn a few things and hardwire this in their brains:

Debt investments aren’t about return maximization. They never were even if you were told so or you misunderstood them. If you want to maximize returns, you need to take risks. And if you need to take risks, do it via equity in your portfolio. Not debt. You don’t want to spend sleepless nights managing debt. Equity does that very well already.

Another lesson that should be learned is that all debt funds are not the same. And I am not just talking about different debt fund categories. Even within a category, some funds behave very differently. And if you open the bonnet of these funds, their engines may have several unwanted components. These are hidden from investors who don’t bother to look. But these are things that should be looked at.

Most investors want high returns irrespective of the asset they are investing in. But at least in debt funds, the source of extra returns shouldn’t come from the hidden additional credit risks embedded in your portfolio.

Actual risk can be very different from the perceived risk in debt funds. And that is the biggest problem. Investors pick the debt funds based on the categories. That is in a way, the category is used as a proxy of the riskiness of funds. But many times, the actual risk is very different due to the fund’s choice of bonds/papers even within the definition of the category.

One more thing that came out in open in recent months is that even though the category of a debt fund may be an indication of the average maturity profile of the fund, the actual bonds/papers held by the fund may be of a longer duration. So an ultra-short duration category will have 3-6 months average maturity profile. But it may hold bonds/papers which are having maturity of 1-2 years as well. Why? Because the category rule is about the average maturity and doesn’t mean each and every component needs to have this maturity limit. Only the portfolio average should be within the definition. So the average maturity can be really deceptive as there’s a big gap between actual maturity/liquidity and what it seems to be at the category level.

SEBI needs to look into this aspect very seriously. A small common investor cannot be expected to know the complexities of debt funds and all this. So in investor interest, if this demands one more round of category rationalization or definition tightening for debt funds, then so be it.

Also, communication from AMCs and product labeling (to highlight marking the risk in different debt fund categories) should be overhauled so that it only attracts the right kind of investors.

I know you must be thinking that isn’t all this the job of fund managers to worry about how to manage the risk in their funds properly?

Rightly said. It is.

But do not forget that it’s your money after all and hence, you should also try to update yourself. You cannot blindly believe anyone. Not even your advisor. And I tell this to my clients as well. Always be learning. Always be situation-aware. It’s good in the long run.

And I missed one more thing. What about mutual fund star ratings? They are a good starting point to get yourself going. But again, don’t trust ratings blindly as by the time ratings are updated, it might be very late for the investors. It has happened in the past. And ratings have an inherent and structural limitation of what can be quantitatively assessed and what cannot be. So be careful about how you base your investment decisions on mutual fund ratings.

Well, that’s it. Enough said.

I am sure you will find tons of articles on how to pick the right debt funds. But I think it is more important to first get your expectations about debt funds right. Only then it should be about picking the right debt fund.

And that reminds me, some time back I wrote a column in MoneyControl about how to set your expectations about debt funds right. Do read it if you have time.

Debt funds remain a decent vehicle to pick from on the debt side of your investment portfolio. A few recent accidents have indeed shaken the faith of many. But it’s a learning for all. I know its easier to say and difficult for those whose money might be stuck. But still what I am saying is correct in my understanding. Debt funds do have the potential to give better and tax-efficient returns. You also get decent liquidity which isn’t available in traditional debt options. So if you make a small effort to understand the debt funds well, then I think you can manage your risks quite well.

And if you are unable to evaluate debt funds from all the vantage points discussed above, it’s really better to take professional advice and not make random picks.

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