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.
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).
Get free money management solutions delivered to your mailbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
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.
🔥Enjoy massive discounts on our courses and robo-advisory tool! 🔥
Use our Robo-advisory Excel Tool for a start-to-finish financial plan! ⇐ More than 1000 investors and advisors use this!
New Tool! => Track your mutual funds and stocks investments with this Google Sheet!
- Follow us on Google News.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Join our YouTube Community and explore more than 1000 videos!
- Have a question? Subscribe to our newsletter with this form.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Get free money management solutions delivered to your mailbox! Subscribe to get posts via email!
Explore the site! Search among our 2000+ articles for information and insight!
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu gets a superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or you buy the new Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low volatility stock screeners.
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our Youtube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)