Are Debt Funds Still a Good Bet?

If you look at the data on debt fund flows for the month of September 2019, redemptions in debt and liquid funds were to the tune of Rs.150,000 crore. Of course, this is partially due to the half-year ending liquidity needs, but pressure on debt funds has been visible for some time now. Specific categories of debt funds like credit risk funds and FMPs have been under pressure since 2018. How should investors approach debt funds at this point of time? Would a strategy of staying out of debt funds and parking in bank FDs work? Or should an investor scout for opportunities in debt funds at this point of time? What are the types of mutual funds to avoid and more importantly what are the best mutual funds to invest in?

Yes, there is a problem in debt funds today

It would be naïve to believe that there is no problem at all with debt funds. For example, the number of downgrades of debt in 2019 has already gone up to 300 if you add up the major rating agencies. That says quite a bit. Additionally, debt issuers have had weak balance sheets as the chart below depicts.

Chart Source: McKinsey

The chart above is quite indicative. India has the highest share of stressed long term debt (taking interest coverage of less than 1.5 as benchmark) across most emerging and developing nations. That has also been one of the reasons India’s ranking in the Global Competitiveness Index has been downgraded in the current year. This stress in the balance sheet has translated into sub-par debt, which was the source of most problems. But debt funds as a category still have a role to play. Here is why!

Why debt funds still add value?

Among the various types of mutual funds in the market, debt funds do have a role to play in providing stability and regularity to your portfolio. If you look at the Morningstar ranking of the best mutual funds in the debt category, most of the sub-categories continue to give positive returns. Negative returns are seen over a 1 year period only in two categories of debt funds viz. credit risk funds and dynamic allocation funds. And in both these cases, the stress has largely come from NBFC debt, which was triggered in the aftermath of the IL&FS default. The good news is that debt funds are reducing their exposure to this segment.

Chart Source: Bloomberg

The chart points that debt funds are trimming their exposure to NBFC debt. Even within the credit risk fund basket, the funds with quality portfolios have still performed. It is only the specific funds, which spread themselves too thin on high yield NBFC debt, that are facing problems. One risk in the last couple of years is that all debt funds are getting painted by the credit risk brush; which is far from the truth. After all, debt funds have an AUM of Rs.13.50 trillion and still account for over 50% of total mutual funds AUM.

5-point approach to debt fund strategy

Debt funds do have a role to play and it does not make sense abandoning them altogether. The need of the hour is a more calibrated debt fund strategy.

1. Debt fund investments must be driven by your goals. Work out debt allocations based on meeting medium term goals. As a touchstone, credit risk funds should not be more than 10% of your debt portfolio; and stick to the leaders.

2. G-Sec funds and income funds are a lot more liquid than credit risk funds. If you have milestones coming up, then you must remain invested in less risky plays and avoid credit risk funds or dynamic allocation funds altogether.

3. If you are thinking about going back to good old FDs, remember that debt funds are a lot more tax-efficient and flexible compared to bank FDs. Long term gains on debt funds can be extremely tax-friendly if you add the indexation benefits.

4. The beauty of debt funds, unlike fixed deposits, is that you benefit from falling rates (as is the scenario now). As a benchmark, a 1-2% fall in rates can enhance returns on long duration debt funds by 4-5%. That really makes them worth it.

5. Investors need to change their perception of debt funds and not equate with a FD in a PSU bank. There are no guaranteed returns in debt funds and the portfolio mix matters a lot. Debt funds carry risks like price risk, default risk and even inflation risk depending on the portfolio of your debt fund.

In a nutshell, debt funds are more about fit than about being an attractive asset class. They surely have a role to play in your long term financial plan!