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How Your Debt Mutual Fund Is Pushing You Into Risky Assets... - Outside View by PersonalFN

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How Your Debt Mutual Fund Is Pushing You Into Risky Assets...
Apr 21, 2017

These days, there's a clear discomfort among investors with low or moderate risk appetite. Even banks have become aggressive in slashing interest rates.

As a result such investors are finding it difficult to scout the right investment opportunities.

Increasingly, investors have been looking at debt funds as alternatives to bonds and fixed deposits.

Do you perceive that debt funds are safe?

They might be safer than the equity oriented funds; however, if you think you won't lose capital in them, you are probably wrong in your assessment.

To understand why they are not risk-free, you first need to know how they function. In principle, debt funds earn interest/income by investing in bonds and other fixed income bearing instruments. Moreover, they also generate returns by trading in bonds and taking advantage of price volatility. As you may know, bonds prices share an inverse correlation with interest rates. To put it differently, when interest rates fall, bond prices rise and vice-a-versa.

What's the present scenario?

In the aftermath of demonetisation, Indian banking system is flooded with liquidity. Since the credit growth has been insignificant, there isn't much pressure on banks and Non-Banking Financial Companies (NBFCs) to raise fresh funds.

As a result, their borrowing cost has fallen remarkable over last few quarters, so much so, that Certificates of Deposits (CDs) issued by banks and Commercial Papers issued by well-run NBFCs are being auctioned at a rate lower than the Repo rate (the rate at which RBI lends to banks for meeting their liquidity requirements), which is currently at 6.25%.

Does this affect you, the investor?

Of course it does. Here's how...

When there's a slosh of liquidity in the system and investors are chasing yields in the view of interest rates are moving lower, even poor quality businesses manage to raise money cheap. In other words, liquidity causes the disequilibrium between the risk and interest rates. In the past, we have witnessed embarrassing situations where well-renowned mutual fund houses have made mistakes that naive investors commit often.

The RBI has already shifted its monetary policy stance from accommodative to neutral; which means depending on the macroeconomic conditions it will exercise any of the options available to it: lower rates, maintain status quo or even raise rates.

Recent inflows in debt funds indicate that, there's some amount of desperation among investors to capitalise on the rally in the bonds. This is highly speculative in nature and may result in ill-assessment of credit opportunities.

PersonalFN believes, when you invest in debt funds, top priority should be given to the risk management measures set out in the investment processes and systems followed by the fund house.

Then, the investment strategy the fund would adopt to build its portfolio to achieve its investment objectives should be carefully read.

If the scheme's investment objective will not address the financial goal(s) you've envisioned, clearly stay away. This will help you have only the appropriate schemes in your portfolio. Before choosing from liquid, short-term, medium-term and/or long-term debt funds, take cognizance of your investment horizon. PersonalFN is of the view that, you should first consider your time horizon before committing money to debt funds and refrain from investing more than 20% of your allocation in long-term debt funds.

You should not invest in a debt scheme solely based on past returns. Pay attention to the quality of debt securities the scheme holds.

PersonalFN's DebtSelect research reports can help you select debt mutual fund schemes prudently and provide valuable guidance on the path to wealth creation. You can be rest assured about the ethical and unbiased nature of this service.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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