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Debt funds can give good returns in 2017

Priya Nair / 12 Jan 17 | 07:54 AM

For Gurgaon-based Rohit Seth, 2016 was a year when he changed his faith as an investor. From being a hard-core investor in fixed deposits and public provident fund, he moved to a debt-equity allocation of 70:30. And he hasn’t been disappointed. His debt funds are earning 12-14 per cent, against the 8-8.5 per cent returns from fixed deposits. And he is wiser as well. “I do understand that debt funds can be uncertain. But I am invested for a minimum of five to six years and in that period, the returns will not be negative. I also don’t invest the money in one go. I invest through Systematic Transfer Plans (STP) and Systematic Investment Plans (SIP)," he says.

Amit Kukreja, Founder, WealthBeing Advisors, is Seth’s advisor. And he has a sound advice for investors looking at debt funds. “Debt funds are not guaranteed-return products. There are times that they can give lower returns than a fixed deposit. However, the possibility varies based on macro-economic conditions, credit risk and interest rate scenarios."

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Santosh Kamath, Managing Director, Local Asset Management–Fixed Income, Franklin Templeton Investments, India says that there are three important risks which investors need to be mindful of while selecting debt funds. These are interest rate risk (change in the interest rates impact prices of underlying bonds as interest rates and bond prices are inversely related); credit risk (lower credit quality portfolios offer higher yields, but that in turn increases the credit risk) and liquidity risk (liquidity is the ease with which portfolio securities can be sold). Lack of demand for a security could lead to liquidity risk. Choosing a debt fund scheme, much like equity, has to be done taking into account the investor’s risk profile. 

How long do you want to stay invested? Most debt funds specify an investment horizon (which is in-line with fund’s maturity profile) where the endeavour is to help investors attain optimal risk-adjusted returns, says Kamath. For instance, investors looking to park their short-term surplus money could look at money market funds, while those with short-to medium-term horizon can look at short-term/medium-term funds. Similarly, investors with long-term horizon can look at gilt funds or income funds, which have exposure to higher maturity instruments. “For short-term investments, one needs instruments which are less volatile and ultra-short term offer that," explains Kaustabh Belapurkar, Director, Research, Morningstar.

However, Abhinav Gulechha, a SEBI-registered investment adviser, says, “I do not select debt fund schemes according to the time horizon of the financial goal. Instead, I recommend only liquid schemes irrespective of the time horizon of the financial goal. The idea is not to chase returns on the fixed income portion of the investment portfolio and at all times, it should be exposed to minimum credit and duration risk."

Interest rate risk: In debt funds, returns will vary depending on which way interest rate cycle is headed. In case of short-term funds, the yields are dependent on the Reserve Bank of India’s policy rates. While in case of long-duration funds like gilt funds, the yields are dependent on macro-economic parameters, says R Sivakumar, Head, Fixed Income, Axis Mutual Fund.

Credit rate risk: A mutual fund will invest in a mix of securities with different credit ratings. These ratings are an indication of the credit worthiness of the borrower. Lower-rated bonds tend to give higher yields. “Typically, in a long duration funds, the fund will not invest in lower rate securities because it will mean taking on both interest rate risk and credit risk," says Sivakumar. 

Credit opportunity funds invest in lower-rated securities which give higher coupon. They can 

offer 150-300 basis points higher yields and are suitable for investors who are willing to take risk. If investing in such funds, make sure that the portfolio is diversified, says Belapurkar. 

Is past performance important? Past performance of the fund may not necessarily give an indication of future performance. For instance, in the last one year long-duration funds gave good returns because of rate cuts. But now that RBI had already cut rates, one must not expect the same returns from these funds, says Sivakumar. It is better to check how many times the fund has beaten the benchmark. That gives an indication of the fund managers’ ability to deliver alpha returns.

Taxation: Debt funds offer the benefit of long-term capital gains with indexation if held for more than three years. This makes them a better investment choice than FDs, says Kukreja.

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