What you need to know about debt mutual funds before investing

The world of debt mutual funds is complex filled with nasty surprises. Here are some facts you need to know about debt funds before investing.

1. Debt mutual funds are not an alternative to fixed deposits! A fixed deposit from a “too big to fail bank” like SBI, ICICI, or HDFC (as mentioned by RBI!) is the next safest investment after a government bond or a small savings scheme. A debt mutual fund is a market-linked product, and returns will fluctuate due to demand and supply factors triggered by speculation about interest rates and credit quality (repayment capability) and changes in interest rate and credit quality (rating). So, the risk is much higher.

2. A debt mutual fund may or may not beat an FD/RD.  This depends entirely on market conditions. No one can predict this.

3. You should know two things about the bonds held in a debt fund portfolio:

(a) Who has issued them? What is the credit rating? Government bonds sold to residents cannot be rated and are classified as “Sov”. The rest are rated AAA, AA, A1+, etc., depending on the duration of the bond and an “estimate” of repaying capability.

The lower the weighted average portfolio credit rating, the higher the expected return! An entity that has difficulty paying interest is expected to pay more interest! Stay away from funds that hold significant quantities of low-rated bonds. Do not chase returns in fixed income. It will almost always end badly.

If the credit rating falls, the NAV will decrease. If a bond issuer defaults (unable to pay back interest), then the NAC will drop vertically down to the extent of the exposure in the portfolio. That is if the fund held 10% of the bonds, the entire amount will be set to zero.

(b) What is the duration of the bonds held? The longer the duration, the more its market value will fluctuate. The longer the time for recovery after a fall. This is because if I hold a bond maturing in three months, I am not too worried about interest rates in this period. At worst (assuming no defaults), I can buy those soon if the interest rates increase and new monthly bonds with higher rates are available.

If, on the other hand, I am holding a 20Y bond and the rates increase sharply or even if there is talk of the rates going up soon, the demand for existing bonds will go down, and their price will drop.

The NAV of a debt fund can change due to both factors. Typically, each day, the NAV increases a small amount due to the interest rate component and due to demand and supply forces.

5: Bond markets can crash like equity markets, and debt mutual funds can feel the heat. If interest rates suddenly increase by a huge amount, existing bond prices (across duration) will fall, resulting in a “crash”. Shorter bonds will recover first. Longer bonds will take months or more.

6: A fund holding only government bonds is not “safe”!  In particular, a gilt mutual fund is not safe! These typically hold long-term bonds, and the NAV will be volatile. When interest rates start to increase or stay the same, returns will be poor.

Suggestion: New debt fund investors should stick to short-term mutual funds like liquid funds or money market funds. These typically investing in safe debt and demand-supply forces will not impact the NAV much. In special circumstances, as the market falls, the NAV will drop even in these funds but should recover fast. Long-term funds can be used for long-term goals, but do not expect a joy ride!

Debt mutual fund resources:

• An introduction to debt mutual funds for new investors
• Which debt mutual funds are suitable for short-term and long-term goals?
• We publish a monthly Debt and hybrid mutual fund screener for selection, tracking, and learning.
• Explore our debt mutual fund article archive. This is the place to be for interested beginners.