Since debt funds are marketed as bank FD alternatives, most investors assume they are risk free with more returns
Instances like Taurus Mutual Fund (MF) marking down their net asset values by 7-12%, among others, pose an important question — Are debt mutual funds actually good bank fixed deposit (FD) alternatives?
Paper loss: With lowering interest rate of bank FDs and small-saving schemes returns, investors have been increasingly looking at debt mutual funds to gain better returns. AMFI data shows that debt-oriented schemes derive 36% of their assets from individual investors. No wonder why instances where debt funds see sharp asset drops scare investors.
Experts say in most cases, especially when a bond’s price falls after a rating downgrade, the loss is a paper loss unless the fund exits the bond at a discount. The fund still earns the interest due on them, and receives the principal back at maturity.
Since debt funds are marketed as bank FD alternatives, most investors assume they are risk free with more returns.
“Increased returns can only come from taking increased risks. Debt funds can give much more returns than a plain-vanilla FD only if they take more risk. Everybody loves returns, but once in a while the true picture of risks will emerge,” says Tarun Singh, a financial advisor.
Not all funds are risky: Debt funds score over fixed deposits in many ways. This holds especially for periods over three years because of the indexation benefit that debt funds have, and because interest on FDs are taxed. There is no tax deducted at source (TDS) in debt funds for resident Indians either. Debt funds have access to papers paying higher interest rates than fixed deposits which retail investors do not. This gives debt funds a better return than FDs.
Investors must understand how debt funds are different from your bank FD. Debt fund net-asset values (NAVs) have to reflect the market price of their papers. Most price reaction is due to interest rate changes. Less frequently, it is due to credit rating changes. Depending on the type of fund it is, there will be chances of losses in the near term.
Respecting time frame is ideal to get best returns from such funds since chance of losses lowers as time frames changes. For example, a dynamic bond fund has witnessed daily or even three-month and six-month falls, say experts. It’s also better than investors avoid funds that take credit calls unless they understand what the risk is.
Debt fund basics: Kaustubh Belapurkar, director manager research, Morningstar Investment Adviser feels that investors must understand the nitty-gritties of debt funds. Debt funds tend to be less risky than equity funds, but usually offer a lower but more consistent return. They are less volatile and the returns from them are predictable since the tenure and the income are known. However, debt funds are associated with some of the risks like interest rate risk, credit risk and liquidity risk.
“Duration funds carry very high interest rate risk while in liquid funds and ultra-short term funds, it’s close to negligible. Credit risk refers to the credit worthiness of the bond issuer, and applies to corporate bond funds since government bond funds do not carry credit risk as they are issued by the government,” points out Belapurkar.
Liquid funds invest in highly liquid money-market instruments and provide easy liquidity. Ultra-short term funds invest in very short-term debt securities with a small portion in longer-term debt securities. Short-term funds invest predominantly in debt securities with a maturity of up to four years. Intermediate/income bond funds invest in corporate bonds, government bonds and money market instruments. Corporate credit funds invest predominantly in corporate bonds seeking opportunities across the credit curve and get benefit from higher yield by taking a higher credit risk.
“Considering the above factors, we still feel debt MF could give better returns than bank FDs. Moreover, these funds are being professionally managed, hence have the potential to yield better returns as compared to bank FDs. However, it is recommended to invest in these funds as per the investor’s risk appetite and investment horizon,” says Belapurkar.
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