Keep Your Faith

Hemant Rustagi
Chief Executive Officer, Wiseinvest Advisors

Debt fund investors have been having a rough ride for over a year and a half now as they have had to deal with a number of defaults and downgrades impacting their investments. Last month, Franklin Templeton Mutual Fund announced the winding up of six of its debt schemes having exposure to higher yielding and lower rated credit securities that got impacted the most due to liquidity crisis in the debt market as a result of the virus pandemic. Consequently, investors will not be able to redeem, switch out or transfer money from these schemes or invest through a systematic investment plan or make lump sum investments in these funds.

While these schemes will continue to announce NAVs on a daily basis, the issue facing investors is whether they will get their monies back and if yes, how much and when. The key factors here are the maturity duration of the portfolio of each of these schemes as well as the possibility of the fund house to liquidate these assets without resorting to any distress sale as well as the ability of the companies to repay the principal and interest on due dates. Broadly speaking, investors can largely expect to get their monies back in a staggered manner.

Needless to say, this latest incident has shaken the confidence of investors in debt funds of other mutual funds too. It triggered a panic-like situation and most debt funds in the industry faced redemption pressure irrespective of the credit quality of the portfolio. The Association of Mutual funds in India (AMFI) was quick to respond to this emerging situation and tried to calm the nerves of investors by explaining that majority of debt funds are invested in superior credit quality securities and they have ample liquidity to ensure normal operations.

The fund houses, on their part, disclosed the latest liquidity position, maturity profile and credit quality of their non-credit risk funds to reassure investors. The Reserve Bank of India too did its bit by announcing Rs 50,000 crore special liquidity facility for mutual funds. Although these steps helped in easing the redemption pressure, investors are faced with a dilemma of what to do with their debt fund investments across the industry. It is important for investors to understand that debt funds, if chosen well, can play an important role in generating higher returns as compared to traditional investment options like bank deposits and small savings schemes. Besides, open-ended debt funds provide liquidity and transparency that is unmatched.

Of course, being market-linked products, there are attendant risks of volatility in returns, interest rates risk as well as credit risk. Therefore, the focus in the current market like situation should be on debt funds that have significant exposure to a mix of AAA-rated bonds, government securities, treasury bills and CDs in varying proportion depending on the type of fund chosen for investment. In other words, avoid funds that expose you to credit risk. Even for existing investments in debt funds, having a close look at the portfolio mix will be reassuring. Apart from the credit quality, another major differentiator among the debt funds is the maturity duration of the portfolio.

Simply put, the longer the maturity, greater is the impact of an interest rate change. Therefore, the key is to choose a fund by matching your time horizon with the maturity duration of the portfolio. In fact, every debt fund has to clearly state its description and characteristics that make it very easy for you to do so. Another major benefit of investing in debt funds is tax-efficiency of returns, especially for investors in the higher tax bracket. While short-term capital gains i.e. gains on investments redeemed within 36 months are added to overall income and are taxed at one’s nominal tax rate, long-term capital gains i.e. gains on units redeemed after 36 months are taxed at 20 per cent after indexation.

Indexation is the method by which the purchase price of an investment is adjusted for inflation. The Cost of Inflation Index (CII) is used to index the cost of acquisition of the debt mutual fund unit. This improves long-term post-tax returns from debt funds considerably as compared to bank deposits and small savings schemes wherein interest earned is taxed at one’s nominal tax rate, irrespective of the period for which investment is held.