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How to pick the right debt funds to suit your goals, timelines

These are difficult and confusing times for debt fund investors. There has been a flurry of bad news because of default by many non-banking finance companies(NBFCs) on interest and principal repayments on their bonds and other debt instruments. These events have dented the confidence of debt fund investors. But in these gloomy times, the banking regulator gave some much needed cheer to the debt markets.
Last week, the Reserve Bank of India (RBI) interest rates by rate by 25 basis points. When interest rates fall, the prices of bonds rise and so do the net asset values (NAV) of debt funds that invest in them. After cutting interest rates for the third successive time this year, the RBI has also changed its monetary policy stance to “accommodative” from “neutral”. Therefore, a rate hike is ruled out for the near future.
Fund managers and debt market experts that Moneycontrolspoke to have indicated that an “accommodative” stance could mean further rate cuts. All this spells good news for debt fund investors.
On June 4, Dewan Housing Finance (DHFL) failed to make a payment to some mutual funds. All funds that held DHFL’s securities in their portfolios immediately marked down the papers in the portfolio by at least 75 per cent. This action of funds is according to  the guidelines that the Association of Mutual Funds of India (Amfi) had laid out a few weeks back. On June 5, rating agencies CRISIL, ICRA and CARE downgraded these instruments to ‘D,’ the default grade. In the interim, debt schemes’ net asset values (NAV) fell; those that had a high exposure to DHFL’s bonds fell the most <see table #1>.

Graphic 1 - DHFL debt funds story

Amidst the mixed news flow, here is how you could choose the right debt fund.

Ascertain your time horizon
Do you want to hedge your equity funds’ portfolio by investing in low-risk debt funds to mitigate the risks? Or are you planning to save for some upcoming expense in the near to medium term such as a holiday or children’s school fees? How long do you want to stay invested and why? The answer to these questions help you pick the right scheme.
Vidya Bala, head of mutual fund research at FundsIndia.com, an online investment platform, says that it’s important to ask ourselves as to why we wish to invest in debt funds. “If you wish to pay your child’s school fees, there is no room for negotiation. Be conservative. Liquidity is important here, so avoid too much risk. For the extremely risk-averse, even a recurring fixed deposit could be better than a debt fund”, she says. Her tip: Avoid chart toppers with a pinch of salt. They have topped the charts mostly because they took additional risk. Go for mid-rung, consistent performers.
If you do not wish to take risks, stick to liquid funds or short-term bond funds that invest in highly-rated instruments. Some short-term bond funds take credit risks; avoid those. Alternatively, take a look at corporate bond funds that invest in only those securities that are rated AA+ and above. According to Morningstar, there are at least eight short-term bond funds that hold DHFL in their portfolios to the tune of at least 5 per cent of their respective overall corpuses. Many other bonds of companies that defaulted in the recent past on their payments to mutual funds have found their way into short-term debt funds.

Large size, diversification important
Size matters. As opposed to equity funds where a small size can be an advantage that ensures that funds (especially mid- and small-caps) stay nimble footed, in debt funds, the larger your scheme’s size, the better.
After DHFL defaulted last week, small-sized debt schemes that held those securities fell the most. DHFL Pramerica Medium Term Fund and DHFL Pramerica Floating Rate Fund, whose NAVs fell by 53 per cent and 48 per cent respectively, had assets of only Rs 35 crore and Rs 13 crore, respectively. The average size of schemes that fell by less than 1 per cent was around Rs 2,500 crore, according to Morningstar data.
Even if you are comfortable taking risks to get higher returns, keep an eye on concentration. Risky (low-rated) securities should not occupy a higher percentage of your scheme’s corpus.
“Some of these debt funds that have been holding such scrips in high proportion also stand a chance of being caught in a tight spot. When they face redemption pressure, they are forced to sell their good quality scrips. As a result, the proportion of such bad scrips rise even higher in- and renders- the portfolio riskier.”, says Bhushan Kedar, director, Funds Research, Crisil.
DHFL schemes faced massive withdrawals at the start of this year. From a size of Rs 438 crore at the end of August 2018, DHFL Pramerica Medium Term Fund’s corpus fell to Rs 18 crore by the end of May 2019. Similarly, DHFL Pramerica Floating Rate Fund’s corpus fell to Rs eight crore by the end of May 2019, down from Rs 641 crore at the end of August 2018. Large-scale redemptions from these funds forced the fund managers to sell their liquid securities. As a result, their holding in troubled bonds such as those of DHFL increased. When DHFL defaulted, the impact was severe on these funds.
Note that size does not guarantee safety or that the fund is better. But risks are spread as large funds are typically diversified.

Past record less relevant
It’s okay to go by past returns when you invest in equity funds. Because bull and bear runs in stocks run for long periods of time. Besides, you also need to remain invested in an equity fund for a time period of at least five years to make optimal returns. Hence, long-term track records matter in equity funds.
But did you know that past returns in debt make little sense? The average two-year returns of short tenured debt funds in 2016 was 8.96 per cent. This was just before demonetisation. If you had invested in debt funds based on this data in 2017 for, say, a two-year period, you would have earned around 6 per cent returns in 2019. Interest rates have been volatile for multiple reasons from demonetisation till date. The RBI had not started cutting interest rates up until 2019.
“Many people invest in g-sec funds based on the past returns of 11-12 per cent that these funds show during falling interest rates. They ask why they should invest in equity funds when g-sec funds can give high returns as well. But if your debt fund has given double-digit returns, it’s unlikely that you’ll get double digit returns for the second year in a row,” says Arvind Chari, Head-Fixed Income & Alternatives, Quantum Advisors.

Graphic 2 - DHFL debt funds story

What should you do?
Debt funds were never risk-free, but investors realizing it the hard way now.
In 2013, investors realised that bond funds have market risks and can give negative returns when the RBI hiked interest rates by 3% in one day. And over the last 3-4 years investors are realising that debt funds also have credit risks and a single company’s default can erase one year returns.
It turns out, they can be more complicated than equity funds. Nearly Rs 713 crore of the outstanding long-term borrowing of DHFL was ‘secured’ non-convertible debentures. Some of these made it into debt funds’ portfolios. The rating of this instrument is now ‘D,’ down all the way from ‘AAA’ in February 2017, despite being ‘secured’.
Debt fund managers are confident that DHFL will repay its loans – it has since repaid its obligations to Reliance Nippon Asset Management on 7 June which, in turn, paid back its fixed maturity plan investors the pending amount. But the risk has spread.Continue to invest in debt funds, but exercise considerable due diligence.