Setting right returns expectations from debt MFs

When it comes to investing in debt funds, people usually keep bank fixed deposits (FD) as the benchmark for returns. If the debt mutual funds are fetching better returns than bank FDs, then they would prefer investing in debt mutual funds. This often leads them to fall into the trap of recency bias, where the recent performance is taken as the basis of the investment. In fact, such a bias is much worst in debt funds than equity funds.

This can be attributed to the recent example of gilt funds. In recent times, gilt funds were giving double-digit returns. What an ideal fund; that too, with no credit risk whatsoever and double-digit returns. Nevertheless, this is just a mere imagination! Debt funds are also risky, even if it's gilt funds. In fact, gilt funds are more prone to interest rate sensitivity. Hence, when interest rate falls, they would rise (as in the current situation) and vice versa. Hence, it is prudent to set the right returns expectations.

To understand this, we would analyse the returns of Sovereign Bond. CCIL All Sovereign Bond Total Returns Index (TRI) would be used for analysing the same.

This is how investors expect their returns to grow. The one-year average rolling returns of CCIL All Sovereign Bond TRI over the period of 10 years is 9.5 per cent, which translates to 0.03 per cent of effective daily returns. However, the reality is quite different.

In reality, returns would be quite volatile. However, they won’t be as volatile as equity. In fact, funds that hold maximum short-term papers are least sensitive to interest rate movements than those betting on long-term papers. Having said, let’s move on to answer the premier question of then what should be the expected returns?

The above graph clearly shows that the pre-tax and expense ratio as in return expectations from the debt mutual funds should not be more than 9.3 per cent to 9.8 per cent. Also, if you notice, it had generated returns of 14.4 per cent to 14.9 per cent but the normal distribution curve seems to be more skewed towards the lower end. Therefore, don’t expect post-tax and expense ratio returns of more than 7 per cent from debt funds.

However, it is to be remembered that these returns expectations are purely for funds at all times having a higher allocation to government securities but the return expectations from the funds such as corporate bond funds, credit risk funds, long-duration funds, etc. need a separate evaluation as they carry a varying variety of risks. Funds with higher YTMs probably possess a greater credit risk, whereas funds with longer modified duration are more prone to interest rate risk.