Are Debt Mutual Funds Losing Their Sheen

A series of defaults and rating downgrades has hurt investors’ perceptions about debt mutual funds. Read this article to find out all that’s happening in the debt mutual fund space right now.

Quite a few conservative investors are mulling over opting out of debt mutual funds and shifting their money to fixed deposits and other low-risk investment products. The IL&FS blowout and a string of downgrades and defaults have dampened the trust of many in the debt mutual fund space. These events, coupled with regulatory changes, have hit the returns of debt plans, leading people to wonder if the risks involved are greater than the returns.

Following the IL&FS fiasco, the Securities and Exchange Board of India has allowed fund houses to opt for the ‘side pocketing’ option. This was done after it was observed that several fund houses had significant exposure in the embattled entity - leading them to take a big hit on their NAV which hurt investor returns. Through the ‘side pocket’ option, fund houses can separate bad assets from other liquid investments in a debt portfolio. This by and large leads to the creation of two resultant schemes - one with bonds that have been downgraded below investment grade by the rating agencies and the other holding the good ones. The framework protects small investors from being hit by sudden exits of large investors. When the illiquidity event is unexpected, side pocketing serves as a cushion to the liquid portfolio.

Meanwhile, a few of the debt funds that witnessed rating downgrades or defaults in their holdings are starting to gradually recover dues. According to a report by The Economic Times, Essel Group has partially paid debt funds. The report further added that Aditya Birla Sun Life MF, ICICI Prudential MF, HDFC MF and Kotak MF have received 45% to 60% of the total dues. DSP Mutual Fund has recovered its entire exposure of Rs.150 crores from DHFL, it stated. These funds previously marked down the value of the securities, causing a drop in NAV. With the dues being recovered, NAVs are also seen to be moving up.

In light of the recent incidents, many are quite sceptical over investing in debt mutual funds. However, it is important to note that if the investment is made carefully - keeping the objective simple and straightforward - debt funds can serve as a good portfolio diversification tool. Here is a look at some of the points that investors should keep in mind before putting their money in debt funds:

• Investments in debt funds should not be made with the intent to earn very high returns. They are more or less close to the returns earned through bank deposits. In some cases, however, they have better taxability as compared to fixed deposits.
• Debt funds are subject to liquidity risk, interest rate risk and credit risk. Movement in the overall interest rate can cause fluctuations in the fund value. There is a risk of default in the interest and principal payment by the issuer.
• Debt funds are further classified into liquid funds, income funds, credit opportunities funds, monthly income plans, fixed maturity plans, dynamic bond funds, GILT funds, short-term funds and ultra-short-term funds. The choice of fund will vary depending on the investment horizon - liquid funds are ideal for an investment horizon of three months to one year, while those who have a longer horizon like two or three years, can select short-term bond funds.
• A longer holding period may be necessary for the debt funds to play out a cycle and also to benefit from the Long-Term Capital Gains (LTCG) taxation, which kicks in after the holding period of thirty-six months.

Investments in debt funds are best-suited for conservative investors. Before putting in the money, however, such individuals are advised to stay up-to-date about the current market scenario as well as the anticipated market performance. In doing so, they will be able to take an informed decision about when, where and what to invest in.

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