The debt funds have seen their returns moderate for some time now. The extent of this fall in returns differs based on the debt fund categories one is invested in. Some categories have been giving negative returns too in some months.
Have a look at debt fund category returns over the last few months below:
Naturally, the debt fund investors are a worried lot as the general perception is, that debt (fund) gives good, stable returns being a comparatively low-risk asset class than equity. It’s a so-called good alternative to fixed deposits in India due to better taxation of debt fund vs bank FDs as indexation reduces debt fund taxes.
The worry is more because when people compare YTD returns, even then it seems that this year might not be so good. True that almost 6-7 months still remain for funds to pick up. But given the underperformance during the first half of the year 2021 (and when you compare it with proportionate performances during the last few years) till now (look at the first column of YTD returns), it seems evident that this year might not be good for the debt fund returns:
So let’s try to make some sense of the decreasing returns of debt mutual funds in 2021 in India.
Before I even get into the technical, here is a very simple thing to keep in mind. Let’s say you expect debt funds to deliver ‘average’ returns of 7% over the long term. Now as I have written earlier too about the reality of average returns, you won’t get 7% every year. Some years will be good while some years will be bad. So if last few years you got decent returns of 7-9% from your debt funds, it’s only natural that once every few years, there will be mean reversion and you will get poor returns for some time. Isn’t it? This is how the averages work and your debt fund return expectation of average X% return will be met.
That is a simple explanation to convince you to be happy with getting lower returns in the short term and for some time. It is part and parcel of investing. You won’t get returns in a straight line (in equity or debt) unless you park money in bank FDs.
Every asset class has its ups and downs. And so will debt and debt mutual funds. As long as you have invested money in well-chosen, high credit-quality, reasonably managed debt funds (and not managed by adventurous fund managers that led to this fiasco and this), you are fine.
Changing rate cycles will lead to the fund managers changing their strategies as well. And that is not a bug but a feature of the fund management industry. So obviously, volatility in returns is inevitable. The funds will see good days (and no one will question them) and also see bad days (when everyone starts asking questions; just like what we are doing in this article!). So to generate reasonable long-term returns from debt funds, you need to stay put with your debt mutual fund. That is assuming you have picked them well.
So which category of debt funds should you be invested in?
That depends on your risk profile as well as your time horizon. But in general with debt funds, do not take unnecessary risks. I continue to recommend high credit quality funds as I have always done (and as highlighted in my Morningstar interview on debt fund. And that I expect takes care of most issues in the debt fund risk spectrum. Temporary return moderation or return holiday is fine. You can’t get good returns every year.
Just have the right expectations from debt funds. Accept that debt funds too can fall at times. They can’t be steady or rise all the time.
Now let me touch briefly on the technical reason for return moderation.
Don’t worry I won’t bore you with a lot of technical stuff like the fund managers and their black-box thinking. I am no expert. But even those who are the so-called ‘experts’, you already know they end up messing things once in a while like this. 😉
Interest rates and bond prices have an inverse relationship. When rates rise, bond prices fall. When rates fall, the bond prices rise. In the context of this fact, understand that when interest rates go up, the returns will be lower. And the degree of fall in returns will depend on the modified duration of the fund chosen. In general, returns will fall sharply (in the near term) for the debt funds that have a higher modified duration while the impact of rising rates will be lower on funds with lower average duration.
I would like to add one thing here. Don’t be too worried about return fluctuation in short periods like weeks or months if you are investing for the long term. When you extend the duration (of investment) under consideration, a lot of these short-term blips fade out. And with that, also don’t try to change your debt fund strategy every few months. Figure out how to choose debt funds correctly first. Then just pick a reliable, repeatable, and reasonable strategy, and then stick with it for years. Don’t flip flop in out of it.
One option for debt fund investors to mitigate low returns is to increase the risk taken to target higher returns. How can that be done? Bu increasing credit or interest rate risk. But I would suggest not to try and act too smart with debt funds. These are different animals altogether. When it comes to the debt side of the portfolio, give more weightage to a peaceful night’s sleep than anything else. Limit all your risk-taking to the equity side of the portfolio. And if this means reducing return expectations from debt funds temporarily, then so be it.
But if you still want to try your hands out in this new (temporary) normal, then make sure you first ‘really’ understand what you are getting to. Deep dive and understand how the risk-return trade-off really works in debt pace. Only then try to venture out. And if you want to participate in the entire spectrum of debt fund maturity profiles, then you can hold a combination of very short, short, medium, and long-term funds in debt fund your portfolio. It would be like having a hypothetical multi-cap debt fund portfolio of your own.
So how low can debt fund returns in 2021 go?
Can you get negative or 0% returns from debt funds?
You never know. Anything is possible. But probability might be very low. But having lower return expectations, in general, would be a good idea. There are no guarantees in financial markets. But indications are there that returns in near future might be lower than what debt funds have generally received in the recent past. So just accept that and don’t try to do too much about it.
And if debt fund return volatility is giving you too much trouble, then reassess whether you should be investing in debt funds at all or not. If it is not your cup of tea, then stick to bank FDs and RDs for short-term and provident funds like EPF, VPF, and PPF, etc. for long-term goals. And if you have doubts about provident fund taxation above Rs 2.5 lakh per year contribution, then get rid of them. The EPF + VPF is still a solid option.
So I hope now you know why debt funds are falling in 2021? And all said and done, I hope you know what should debt mutual fund investors do in 2021? You might be tempted to increase the risk in order to get higher returns. But I would suggest against doing this. Just focus on risk management, stick with high credit quality funds and relax. And reset your return expectations a bit and be ready for returns being a bit lower than what you have earned in the past from debt funds.