Debt funds have been popular among investors with low-risk appetite due to the relative safety of capital and the possibility of moderate returns. These funds invest in fixed-income instruments such as bonds, which assures returns to a degree.
However, the sharp decline in debt funds in February has shaken up investors. Except for liquid funds, most debt fund categories saw a fall following the RBI’s monetary policy committee decision to maintain its rates. Some debt funds fell as much as 7% in a single day.
Let’s try and understand what went wrong.
Additional Reading: Risks in debt funds
Why these funds lost money
A section of the investment community expected the RBI to continue cutting rates in continuation with what it had done in the last two years. The interest rate had fallen steadily, inflationary pressures had eased out, demand had reduced during demonetisation, and bond prices had gone steadily up. Bonds being their underlying assets, debt funds appreciated in this period.
However, the RBI did not lower the rates further in the last two monetary policy reviews, as inflationary pressures have been gaining ground, led by factors such as the increase in oil prices. The following day, debt fund NAV reacted with a sudden, sharp drop.
Another trigger for the fall was the drop in value of four schemes of a prominent Mutual Fund company, which invested around 12% of the fund value in the securities of a firm struggling with its finances. The net asset value of that fund fell between 7 and 11% in a day. This is an instance of investors and advisors blindly following third-party credit rating agencies which sometimes rate troubled firms highly in their rankings.
Risks in debt funds
What makes an asset risky in financial terms is the volatility associated with the returns. Unlike other market instruments, debt funds are considered less volatile, promising capital preservation. However, what makes them risky are return optimisation and miscalculated predictions.
Let’s understand the risk involved under the following circumstances:
- Unexpected change in interest rate:Bond prices are inversely related to the interest rate. Investors typically put money in bonds when the interest rate is poised to fall, and therefore, the price is determined accordingly. At such times, debt funds are marketed as instruments for return optimisation, not just as a mode of capital preservation. Fund companies try and invest in long-term bonds expecting steady returns, thus driving the market price up. However, when the prediction of the future course of rate change is miscalculated, these funds suffer. This played out on February 8 after the prediction for rate change fell flat.
- When the fundamentals of underlying companies deteriorate: When you invest in debt funds, your fund gets invested in debt scribes of companies, and they pay back the principal and interest on completion of the loan tenure. Investments in such funds are done on the basis of assumptions made about the future business prospect, project cash flow, and revenue estimation etc. of a company. The returns might not arrive as expected if the business doesn’t fare well and the company defaults. Sometimes, a bond is rated low by rating agencies due to change in fundamentals, dampening the prospect of payment.
That said, do not let short-term course corrections throw you off your decision to invest in debt funds. These have the potential to provide marginally better returns than Fixed Deposits with a higher tax efficiency. If you have suffered losses, you may try remaining invested for the long term in order to ride out the volatility. Additionally, you could invest in a controlled manner through SIPs instead of lump sums for better cost averaging.
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