How to pick the right debt fund?

Debt funds or a segment of the investment spectrum perceived to be stable and safe for the retail investor have come under pressure. However, experts feel that this asset class still has some value for the retail investor and are not ready to write off this asset class as an investment option yet.

"Debt funds are still a good investment class; investors just need to pick the right set of funds," said Kaustubh Belapurkar, director - manager research, Morningstar India. Debt funds are mutual funds that invest money in fixed interest earning instruments such as Treasury Bills and Certificate of Deposits.

The prime focus of a debt fund is to generate wealth via interest income and appreciation of the invested funds. Such debt funds have come under pressure, and negative news recently, due to some unwise investment decisions by the fund managers of these funds.

Investors need to be aware of the two major risks in fixed income investing – credit risk and interest rate risk. Different fund and fund categories have varying levels of these two risks.

"There are still certain AMCs (asset management companies – MFs) that remained undeterred by the NBFC crisis," explains Prateek Pant, head of products and solutions, Sanctum Wealth Management. Asset quality was maintained as the fund manager and the AMCs in their investment processes did not deviate from the quality. Debt MFs are dependable and provides superior post tax returns, affirms Pant.

"Even within the overall debt fund universe, only certain funds have been affected and not the entire investment spectrum," says Harsh Jain - Co-Founder & COO, Groww. Thus, lower risk debt funds such as liquid funds were relatively unaffected by the crisis.

The woes of the debt MF category started with the increase in investments into this sector. With the increase in fund allotment into this sector, Credit Risk funds started seeing significant investment. Credit Risk funds invest in companies that have lower ratings by rating agencies (Crisil, Care, Icra, SMREA, Brickwork Rating, and India Rating and Research) as they may give a higher rate of returns.

The investment into non AAA ratings has increased to around Rs 2 lakh crore according to Morningstar Research.

In Sep 2018, the stress around IL&FS group started which then caused a sentimental impact on several other NBFC names which caused a liquidity crisis.

Companies such as Dewan Housing despite having a good quality loan book came under stress due to the asset liability mismatches and couldn't refinance their borrowings, which caused further stress as they had to sell down their loan books as well as make strategic asset sales to pay back bond investors.

The asset investment into Debt funds as on May end stood at Rs 156,458 crore. Of this approximately 5% or Rs 7,823 crore would be impaired or non-performing assets, according to date complied from ACE MF and Sanctum Wealth Management.

Experts, however, are still positive on the outlook for debt funds as an asset class.

"Given the debt market outlook, with inflation well within RBI's expectations, benign growth and the central bank's accommodative stance, debt funds are in a position to reward investors suitably, going forward," says Jason Monteiro AVP - Mutual Fund Research & Content Prabhudas Lilladher.

The RBI is taking steps to improve liquidity, a move that is expected to benefit short duration funds, as yields on short-term securities is expected to drop when liquidity conditions improve.

Monteiro also points out that investors tend to panic at bad news on their investments, even though in this context the total impaired assets as just a fraction of the overall AUM (assets under management).

So what should an investor who has invested into debt funds do? Stay invested or exit?

"Investors should look at the holdings (investments) of their debt funds," says Jain. Debt funds with large AUMs have diversified well and are unlikely to be jolted by the poor performance of one or two bonds. "Choose good quality debt funds with good diversification," says Jain.

"You should not sell unless the scheme (where you have been invested into) has been an underperformer or if a significant portion of the portfolio is exposed to AA or below rated papers, which may not be suited to one's risk appetite," says Monteiro. So unless there is something fundamentally wrong with the debt schemes you are investing in, you should continue to hold the scheme till the goal of your investment is met.

And if you are a new investor? If you don't have debt MFs currently in your portfolio?

"Investors need to carefully understand their risk-return objectives and then pick suitable fund categories and funds," says Belapurkar. Each debt fund is suitable for a certain risk profile and these risks should be understood clearly before investing. Certain categories such as medium duration and short duration will have some funds that take on greater amount of credit risk, so investors need to be cognizant of that and invest according to the risk-return objectives.

"One should focus on the right fund based on their investment horizon, risk and liquidity," says Monteiro. A scheme may be the best fund in the category based on past returns, but it may have invested in lower rated papers to generate a higher return. Thus, investing in such a scheme may expose investors to risk that they may not be comfortable with.

"Avoid investing in small-sized debt mutual funds which have a very concentrated portfolio and debt funds with high-interest rate risk," advices Jain who ends with the fact that the main purpose of debt funds is to provide low-risk returns to the investor with liquidity, and there are few other alternatives in this space.