We may not forget April 2020, when we woke up to rude shock of Franklin Debt Funds, Fiasco. Franklin announced abrupt closure of 6 of their Debt fund schemes. Over 25000 crores of investors’ funds hung in limbo. Spooked by this, investors turned risk-averse, which resulted in massive outflows from Credit- Risk Funds. But for Franklin, the blow was across its category of funds, right from Short term/ Ultra Short term, Dynamic Fund/ Income Fund to Credit-risk fund. Scores of investors have parked their life’s savings in these Funds which undertook higher risk, to garner additional 1%-2%.
It’s imperative that investors understand these key RISKs, that any DEBT Fund carries, especially during these unprecedented times.
To be honest, this was not the first time it happened with a Debt fund investor. Rather it’s quite regular, every second year we witness something on similar lines. It was an outcome of few common wrong notion investors have about debt fund.
❌It’s (Debt Funds) something which will fetch returns better than FD.
❌It’s just open and shut. Can invest blindly in it just by checking past performance.
❌It can’t fetch negative returns.
Where most investors read debt funds wrong?
1. Choosing DEBT funds basis Star Ratings: Most of the online advisory portals have created a mechanism to bucketize and categories funds for ease of understanding. They have created rating mechanism to help investor make out a better performing funds.
However, the biggest flaw with this rating mechanism is that they consider past Returns to be a key Indicator of performance within a category. Not considering the quantum of risk-reward its currently undertaking and Return expectation customer should have from it.
This can be really misguiding while selecting an appropriate DEBT funds. Funds in a particular category which may have invested in Low Rated papers to fetch Higher Returns continue to get rewarded by Higher Stars. This exactly happened while Franklin Funds were rated. There is no weightage given to the Credit Quality of Securities held in the fund.
YTM: (Yield to Maturity): A DEBT fund is a bucket full Bonds, issued by Private/ PSU/Govt institutions. The average interest of all these bonds can be gauged from YTM of the fund, reduce expenses from it to get the real picture of what you will be getting in hand for a specified duration.
3. Considering DEBT Funds as a Fixed Deposit: The key difference between Debt Funds and any Fixed Deposits is that the bonds held in Debt Funds are tradable and Marked to the Market, and its NAV is published on daily basis, unlike a Fixed Deposit where the interest rates remain fixed. Also, since most of the DEBT funds are dynamic, their Yield to Maturity continue to vary from time to time.
4. Not having a peep inside: Credit Risk: Say you lent Rs 1 lac to a friend and he goes bust. Now, your Rs 1 Lac is at risk, and you might not get the entire amount, and not sure when will you get that. This is Credit Risk.
Don’t judge the book by its cover. Just going by the past performance of DEBT fund will not help. Or even a high Current Yield to Maturity may the give the right information on what securities fund is holding that is helping you get higher returns, unless each security is understood, and a broader view is taken.
5. Interest Rate RISK? Will you be happy when interest rates go thinking the your Existing Debt fund will fetch more returns now? Sorry, but don’t be so. Yields of Debt funds are inversely related to Interest rates. When interest rates go up, Value (NAV) of your existing debt fund will come down, except overnight funds. How much? Well, that will depend on the duration of the fund. Another key metric investors need to understand.
6. SEBI categorization: In its circular dated 6th Oct 2017, to categories and rationalize Mutual Fund SEBI has bucketed DEBT fund universe in 16 different categories, defining where they can invest and duration size of the Fund. For Ex. Overnight Funds must invest in securities of 1 day maturity only, and Liquid Fund can invest in securities having maturity of maximum of 91 days.
Long story short, DEBT funds are equally complicated as Equity funds are. And yes, if not chosen right, investors may very well have to face the risk of capital erosion and negative returns. Unfortunately, there is no single metric available which can help you find the right Debt Fund.
Which will be the Right Debt fund for you? Drop an email to me at Yogendra.firstname.lastname@example.org