Debt funds are not as "safe" as they sound. - The Honest Truth By Ajit Dayal
Investing in India - Honest Truth by Ajit Dayal
Debt funds are not as "safe" as they sound. A  A  A
20 APRIL 2013

A client who wishes to minimise risk says: "I want to be really safe, please make sure your PersonalFN financial planner puts all my money in a debt fund."

And that, right there, is a dangerous misconception.

Debt funds are not "really safe". They have a lot of inherent risks in them which you should be aware of before you decide to invest in them - even if they have been recommended by your financial advisor.

And for the "extra risk" that you have taken in debt funds compared to liquid funds (or bank FDs), you should be compensated with a higher return.

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Safety is not assured.

A debt fund invests in securities which, typically, mature more than 90 days. Most debt funds may have investments where the average maturity is anywhere from 3 years to 7 years. A liquid fund, by contrast, invests in securities that mature in less than 90 days.

The longer one is invested in something, the higher the chance that something can go wrong: the risk increases.

For example, if you lent money to your neighbour for one day, the "risk" of him not paying is limited to that one day. You will make your decision on whether to lend (or not to lend) looking at various factors that could go wrong (or right) in that one day period. "Is your neighbour likely to disappear overnight?" may be your first question!

But what if the neighbour asks you for a loan for 10 years because he wishes to build a factory to manufacture cars? Now your entire assessment of the loan should have changed. In addition to worrying about whether your neighbour will disappear for 3,652 nights (10 years x 365 days plus some lap year days!), you need to start asking him a whole bunch of questions (why cars, what is the demand, competition, service centres, where will he get the money from, when will he start production, where will he get his raw materials from, etc., etc.). And you will also worry about the rate of interest you should charge him. If you charge him, say 10%, you will feel foolish if the rates of interest surge to 20% next month. If you had not locked in your money at 10%, you could have been a lender at 20%. However, if the rates of interest decline to 5%, you will feel good that you locked in your loan at 10%.

Keeping this basic principle in mind: the longer you are locked in, the higher your "risk", here is a graph of two funds from HDFC Mutual Fund: one is a liquid fund and the other is a fixed income fund.

Graph 1: HDFC Fixed Income Fund does better than the HDFC Liquid Fund, from October 2000 till March 31, 2013.

The HDFC Liquid Fund has a portfolio with an average maturity of 53 days, as per the fact sheet of March 31, 2013.

The HDFC Fixed Income Fund has a portfolio with an average maturity of 9.45 years, as per the fact sheet of March 31, 2013.

Note how the HDFC Fixed Income Fund - with a relatively higher risk than the HDFC Liquid Fund because it is locked in securities that mature after 9 years - has performed better from October 2000, when both the Funds were in existence.

But note the jagged lines of the HDFC Fixed Income Fund. Those jagged lines are a result of the daily changes in interest rates which impact the value of the underlying holdings of the HDFC Fixed Income Fund. And this is in contrast to the relatively smooth line of the HDFC Liquid Fund.

Investing in HDFC Fixed Income Fund is like lending money to your neighbour for 10 years - several unknowns impact the 2 key factors: "will I get my money back?" and "at what interest rate should I have lent the money?" And you may worry about this every day - with varying degrees. So, that jagged line represents this continuous worry over long periods of time.

Investing in HDFC Liquid Fund is like lending money to your neighbour for 53 days (that is the average maturity of the securities it owns), getting it back from him, and deciding to lend it to him again for 53 days again - sort of rolling over the loan within a short period of time, if you felt like it. And if you feel uncomfortable - because something may have changed in your assessment of his ability to pay, or even in the interest rate you wish to charge him - you can decide not to roll over the loan. The smooth line represents the "53-day" worry.

Of course, like in any investment, when you invest also determines whether you made money - or got compensated - for the higher risk.

As you can see, an investment in the HDFC Liquid Fund would have given you better sleep (fewer jagged lines) and a better return than an investment in HDFC Fixed Income Fund since January 1, 2004.

Graph 2: HDFC Liquid Fund does better than HDFC Fixed Income Fund, since January 1, 2004.

Recognise that a liquid fund and a debt fund both own securities which give a fixed rate of return. But the funds are different. And you need to be aware of that and see whether it matches your potential needs.

Table 1: Why the Funds are different
  Liquid Fund Debt Funds
What does the Fund typically own? Obligations of a borrower to repay a certain amount, called the principal, at a fixed time Obligations of a borrower to repay a certain amount, called the principal, at a fixed time
Interest earned on investments? Typically 7% to 8% Typically 8% to 10%
Tenure: when will the money be returned to the Fund? Has to be returned within 90 days Ranges between 3 years and 8 years
Can these holdings be sold by Fund to someone else, is there a secondary market? Yes, these are traded actively but most Funds will hold these till they "mature" and the borrower repays the loan Yes, these are traded actively and most Funds will sell them in the secondary market
What happens if interest rates surge sharply? Can reinvest quickly in instruments that give high interest rates Stuck - will take a longer and larger hit on the portfolio value, the NAV
What if interest rates fall sharply? Will be forced to reinvest the portfolio at lower interest rates, then the future returns will decline - but no long term loss on the portfolio value, the NAV Will see a large surge in the value of its portfolio of existing securities, surge in NAV
Should this be in your portfolio? Yes, as an alternative to Fixed Deposits, particularly if you need the money in a shorter, unknown period of time Only a small proportion of your "fixed income" portfolio should be in this; this actually is for more sophisticated investors who wish to "make a call" on the direction of interest rates
Typical commissions paid by mutual fund houses to distributors and financial advisors who "sell" this product? 0.05% to 0.10% 0.30% to 1.0%
Source: PersonalFN

Investors looking to invest in instruments which have a fixed rate of return and want to ensure that their capital value is secure should consider:
  1. The various tax-incentive saving schemes like Postal Savings,

  2. The Fixed Deposits at different banks,

  3. The Liquid Funds.
The rates of return in these above instruments may not compensate you for the increase in prices, for inflation. But your capital is safe.

For those wishing to earn higher returns to beat inflation and take some risk on their capital, there is the option of investing in the various debt funds. They may be called FMP, monthly Income products, or debt funds - but recognise that their underlying portfolios are subject to more risks than the liquid funds. And there could be sharp changes in the NAVs on the date you redeem and ask for your money back - and these may affect your rate of return.

Again, there is nothing wrong about fixed income funds - Graph 1 shows how the HDFC Fixed Income Fund has performed better than the HDFC Liquid Fund since October 2000. The points to note are:
  1. the risk (the jagged line) and whether you have been compensated for the underlying risk,

  2. you may end up redeeming at the wrong time -when the NAV has declined - resulting in a potential loss or in a much lower return than in the "more safe" liquid fund (as Graph 2 indicates).
At the end of the day, you should be invested in various asset classes (fixed income, equities, and gold), in different instruments within each asset class (for example in "fixed income" invest in FDs, liquid funds, debt funds; in "equities" invest in a way that gives you exposure to large cap, mid cap, and small cap stocks) in proportions that suit your ability to take risks.

A well-diversified and well-thought out investment plan will help you ride out the bumps of investing. At the end of every Honest Truth, there is a table for you to see how one can decide asset allocations across various asset classes depending on future estimated needs. But your goals and risk appetite will be different from others, so you should tweak this to suit your needs - or consult a financial advisor to help you with the exercise.

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Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
Quantum Liquid Fund
Why you
should own
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.

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