Last Updated on March 20, 2021 at 9:05 am
A sentiment that has gained popularity after the Franklin debt funds fiasco is, “avoid all kinds of risk in debt funds”. Now I notice investors preferring liquid funds even for long-term goals stating they cannot tolerate any NAV fluctuations. Does it make sense to use such short-term funds like liquid funds even for long-term goals? Are there any risks in doing so?
In this article, by “liquid fund”, we shall refer to all “money market” fund categories of overnight funds, liquid funds and money market funds. The credit risk in these categories is reasonably low, and interest rate risk or duration risk resulting from demand-supply fluctuations in the bond market is also fairly low.
We shall exclude ultra short-term funds as they could get into low-rated bonds, although the Franklin episode would have at least temporarily spooked AMCs to play it relatively safe.
We shall assume the investor is currently in the 20% or 30% tax slab or is likely to be in the next few years. This is why they are looking for debt funds, as the returns would be tax-efficient than an RD or FD.
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Given these assumptions, does it make sense to use such “liquid funds” for long-term goals, say for more than five years? We must recognise there is more to “risk” than just fluctuations in the NAV. Credit risk is one such unknown risk. Until it hits us, we rarely appreciate it. Or we go overboard in our fear and equate credit risk and redemption risk (Franklin case).
Another unknown risk is reinvestment risk. This is when subsequent investments earn a lower interest rate. All PPF investors can readily appreciate how much the rates have fallen over the years.
In the case of debt funds, the longer the duration of the bond (whether issued by the govt to a corporate), the more the NAV will fluctuate on a day to day basis. This is because no one in the bond market wants to be caught on the wrong foot: buy a long duration bond just when the new bonds’ rates are going to increase.
So just like stocks prices and gold prices are subject to speculation, so are bond prices, particularly the long-term segment. This is why many investors fear gilt funds, even though there do not have any credit risk. Their returns can fluctuate from spectacular to negative or go through periods of poor returns. Again the risk is visible, and investors are wary.
In the case of liquid funds and money market funds, the NAV typically tends to move up “smoothly”. Of course, over a period of a few months, we can see changes in the rate of increase (meaning varying returns).
If PPF is subject to reinvestment risk (gradually decreasing interest rates over a person’s investment tenure of 15 years), then the same logic applies to all short-term funds. If the govt. decides to lower PPF rates. It would automatically mean short-term bonds would have a lower coupon rate (there are some exceptions to this, but those should, in all probability, for a healthy economy not last for too long – the last we had this situation was in late 2013).
Of course, interest rates do not decrease smoothly. There would be intermittent periods of high rates and, therefore, liquid funds buying newer bonds with a higher coupon rate. Still, over a decade or more, the direction can safely be expected to lower.
Just like we have no idea what return we can get from a long-term gilt fund if held for a few months to few years, there is no way to make a return estimation from short-term debt funds over a decade due to this reinvestment risk.
The essential message for investors is, you can run but cannot hide from fluctuating returns. So what should investors do? Just as there is a lot of “Gyan” to stay invested and get used to the volatility of equity mutual funds, investors should learn to get used to debt fund NAV volatility and shy away from them if their tenure is long enough.
Alternatives like corporate bonds funds, PSU and Banking funds etc., will also exhibit NAV volatility due to supply-demand fluctuations and credit rating fluctuations. Again, no place to hide. There is always some risk that would chase us.
Expecting 6% returns from the money market category of mutual funds over, say, 7-10 years and getting less is a bigger risk than expecting 6% returns over the same period from gilt funds.
Arbitrage mutual funds also suffer from gradually changing returns. If there are not enough players in the futures market, returns will dry up. Thus there is always some form of variable return risk to fight. As always is about making an informed decision.