Why Your Debt Fund Will Ditch You?

The last week of March 2020, was extremely chaotic, uncertainty loomed. A never heard before the lockdown was shaping up in India, almost 90% of the world was in the acute grip of Covid-19. Equity Markets across the globe were falling like a pack of cards. The world witnessed one of the sharpest Equity Market corrections.

And this was the time I was inundated with phone calls, as anxiety amongst investors ran high. Though surprisingly many of these calls were not for Equity Meltdown, rather investors were worried about a sudden fall in NAVs of their Debt Funds. Well, the reason was, in the second half of March 2020, Debt Markets witnessed a major sell-off from FII, State Govt. borrowed heavily, and Bond Yields rose sharply.

FII Sell off? Bond Yields Rising?

What the heck? What have these got to do with my Debt Funds? They are supposed to fetch me stable Returns.

I’m sure these will be the questions popping in your mind too. Don’t worry, I will simplify Debt Funds for you and will also Bust the MYTH ‘Debt funds are not Volatile’ and why You should not worry If you have invested Right. Read on…

DEBT FUNDS carry 2 Risks, Which the Majority of investors are not aware of:

  1. Credit Risk:  Simply, Credit Risk means -the Creditworthiness of the Companies to whom your debt fund Manager has lent money. Be it Institution or Sovereign (Country), all are Susceptible to defaulting on payment of Timely Interest and Repayment of Capital back to the lender. Hence, it’s imperative for you to understand as an investor where your Debt Funds invest. How Strong Companies/ Institutions are to whom your debt Fund is Lending to.

The strongest creditworthiness will be attributed to Central Govt. bonds/ State Govt & PSU Borrowing as they carry sovereign Guarantee and are termed as unshakable. Further, in Private Companies, AAA Rated Company is considered to be the Strongest to invest in, but with changing tides as we are currently in, a Fund Manager needs to be extremely careful in picking the right set of even AAA-rated companies.

In a situation where any of the Securities held in a Debt Fund will fail to make timely Interest payments OR Principal Repayments OR its Credit Rating Gets downgraded, A Debt will take a HIT.

  1.   Interest Rate Risk:  Once you have chosen a Bulletproof Debt Fund, with Strongest Securities, you will still be subjected to Interest rates volatility. Let me explain you this:

Since all Debt Fund Securities are Traded in Secondary MarketConsider this Example:
You make an FD of INR 1,00,000 at 10% Annual Interest for 3 Years, with Bank X. Hypothetically considering this FD (though FD is non-transferable) is transferable, means you can sell it to someone midway. After 1 Year Interest rates fall down to 8% (FD Yields have fallen) and you won’t sell your FD Bond which fetches you 10% (The Coupon Rate) and still 2 years to go, You will command a PREMIUM on the Price of FD ( Principal Amount). This is because the buyer will get 2% additional Interest (10-8=2%) for the next 2 years, which means (Layman’s Language, though there is a formula to calculate this) now your FD will sell at a premium of 4% or Rs 4,000/-

Similarly, if benchmark Interest rates go up by 2% to 12% after 1 Year (meaning FD Yield have RISEN), Your FD will sell at a DISCOUNT of 4% or Rs 4000/-. Hence the Price of FD (Bond) will quote a Negative value.

In the Bond market, Bonds are traded on a daily basis, price of bonds fluctuates daily, mildly not wildly, barring some of the Unprecedented situations like we are currently in. And this is the reason your debt funds are showing negative returns since the last 1 Month’s Yields were very volatile.

Yields of a 10 Year Benchmark India Bond: Yields have risen from 6.05% on 9th March to 6.49% as of 9th April 2020. The rise in yield, go back to the above example, means a fall in the price of bonds which Debt Fund holds. Though these rises & falls are notional and called as Mark to Market.

Be Careful: How can you choose the Right Debt Funds for Yourself.

  • Be sure of how long you wish to park the money in Debt Fund. What is your ultimate objective? You wish to park for a very short term, say 10-15days. Or You wish to benefit from lower taxation of Debt Funds offers over FD, with Safety.
  • Get to understand Fund Mandate: Like Overnight Funds are the Safest for Very Short term 1- 30 days. They park most of their money in Govt. securities. If you have 3 years horizon, Safety First, Tax Benefits- you may choose Corporate Bond, Banking & PSU debt funds.
  • Very Importantly: Invest Right and if you have invested for a particular time frame, don’t check the NAVs daily. At max. you may do once in quarter review and check-in during the turbulent phase.

Remember: Short-term volatility never impacts long-term investors.

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