Debt funds see selling but investors can look for better times ahead

Are investors reading the debt market signals correctly? At a time when many investment experts hold a constructive view on fixed income, the investor community seems to be shunning debt schemes of mutual funds. As per monthly data released by Association of Mutual Funds in India (AMFI), debt funds saw net outflows of Rs 10,316 crore in January 2023. The selling has been widespread. A total of 11 out of 16 debt fund categories have seen outflows.

This is not surprising as often investors tend to run away from an asset class when they should ideally be investing in it. For example, when equities are down and market valuations become ripe for buying, investors may become fearful and sell. This time is no different for debt investors.. In fact, while investors are trimming their debt holdings this could actually be a good time to latch up on them.

The fault, of course, is not squarely on investors. Investing in debt funds has been a volatile journey in the last two to three years. Retail investors prefer to invest in short duration funds, corporate bond funds and banking and PSU debt funds. These have given less than 5% returns in most cases. For Gilt funds and long-duration funds, the numbers are even lower. When an individual looks at this anemic performance, he or she may be keen on moving out.

But before one opts out, it might pay to understand the debt fund mechanism. Debt funds have posted poor returns because interest rates were going up. The Reserve Bank of India has already hiked the repo rate — the rate at which it lends money to commercial banks, by 250 basis points since May 2022. When the interest rates go up, bond yields follow and the bond prices fall as there is an inverse relationship between bond prices and yields. No wonder, in the rising interest rate scenario debt funds holding on to bonds, saw their net asset values (NAV) come under pressure.

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While the upward movement in bond yields has hit investors so far, it has also elevated the portfolio bond yields of the debt funds to very attractive levels. For example, many well-managed short-duration bond funds have portfolio yield-to-maturity in the range of 7.4-7.9 percent. It means someone investing in short-duration funds now will get to own bonds offering such attractive yields and holding on to them can pocket the returns closer to yield-to-maturity minus the expense ratio of the scheme. So, if an investor buys into a short-duration fund with YTM of 7.5% with an expense ratio of 50 basis points, he/she will get to keep around 7% returns.

And this is just one part of the investment thesis. The future may hold even better news for debt investors. The booster is expected in the form of falling bond yields going forward. Many experts are of the opinion that most of the interest rate hikes by RBI in the current cycle of taming inflation are done. If we go by what they say, and expect the bond yields to drop towards the end of CY2023 or in the first quarter of CY2024, then these bond funds will report higher returns due to capital appreciation on the bonds held as bond prices will rise.

Though all this looks good and may work out too, there are many investors who cannot withstand the volatility the debt markets bring in. Even if they agree that the YTM are attractive, the moot question they face is what if the rate hike cycle drags on and the yields go up again resulting in debt funds continuing to show muted returns? Risk-averse investors look for some assurance on the returns on their investments. For them, there is the option of investing in Target Maturity Funds (TMF) where there is higher certainty of final returns at maturity. TMFs have a fixed maturity date and they invest in high credit rated bonds.  The YTM on these schemes are also known and as they move closer to the maturity date, the sensitivity to the changes in interest rates reduces. Put simply, if an investor holds on to the units in TMF then he/she is expected to take home the YTM minus expense ratio of the scheme, irrespective of the movement in the yields in the interim period. There is no need to panic, and no need to worry about the fund manager making mistakes. However, investors need to choose debt schemes that have duration in line with their holding period. This is more likely to minimise the impact of interest rate risk.

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Tax efficiency can be another reason why debt funds cannot be ignored.  For those in the higher tax bracket, debt funds are a better option to take exposure to fixed income compared to instruments such as fixed deposits. Debt funds have a lower tax incidence if held for a longer duration. While the interest gets added to income and taxed as per slab rate, the capital gains booked on units held for more than three years, are taxed at 20% post indexation.

(Sarbajeet K Sen is a senior financial journalist.)