De-mystifying Debt Mutual Funds – Where they Stand?

After understanding the basics of debt mutual funds in Part I of this series, we now look at the benefits and risks of investing in debt mutual funds, and how they stack against fixed deposits, other debt and equity investments. We also look at some lessons from history to guide future investment decisions.

Benefits of Debt Mutual Funds

Tax Deferral

Debt funds are taxed only when you withdraw money vs. annual tax on interest on FDs and other deposit. This allows the unpaid tax portion to also keep compounding. Further, SWPs can be structured to replicate the periodic interest payout in FDs, deferring a large portion of tax to final withdrawal (from annual taxation). We cover taxation of debt mutual funds in detail in Taxation of Debt Investments.

Granular Liquidity

Partial withdrawal is possible in case of a debt mutual fund, subject to any exit load. Fixed deposits, on the other hand, need to be prematurely withdrawn as a whole and may entail penalty.

Diversification across Bonds

A single fund invests in 50-100 different bonds. This minimizes concentration risk compared to directly investing in a corporate bond/deposit.

Portfolio Diversification

Debt funds provide stability to the overall portfolio, partly offsetting the high volatility of equity investments. As Benjamin Graham mentions in his book ‘The Intelligent Investor’ – “We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks”.

Dual Return Potential

Typical fixed income instruments like Fixed Deposits only give interest income. However, debt funds have dual return potential - if market interest rates fall, bond prices rise – resulting in capital gains as well in addition to interest income. A good fund manager in a dynamic bond fund can add further alpha to this if he is able to predict the interest rate cycles well.

Risks in Debt Mutual Funds

Interest Rate Risk

The risk that bond prices will fall as interest rates rise. Highest in Gilt and Long Duration funds. This risk does not exist in fixed deposits.

Credit & Default Risk

The risk that the borrower's credit rating deteriorates or the borrower stops paying interest or principal. Highest in Credit Risk funds. This risk is very low in fixed deposits and insured upto ₹5 lakhs per bank per investor (only for bank FDs).

Liquidity Risk

The risk that the fund manager cannot sell the underlying bonds quickly enough to meet redemption pressures.

Re-Investment Risk

The risk that interest payments received will be reinvested at lower rates (common in a falling rate regime). However, this risk exists in fixed deposits and other fixed income instruments as well.

The overall effect of the above risks is that though debt fund returns are stable (compared to equity), they are not ‘fixed’ like an FD or a corporate bond.

Lessons From History

The Scars

IL&FS Crisis (2018)

An AAA-rated entity defaulted, triggering panic. Many "Liquid" and "Short Duration" funds that held IL&FS paper saw their NAVs drop overnight.

Lesson: Ratings can lag reality

Franklin Templeton Winding Up (2020)

The fund house shut down 6 schemes because the bond market froze during COVID-19. They had invested in lower-rated, illiquid bonds and could not sell them to pay exiting investors. Lesson: Liquidity is king

Borrower Events

Yes Bank AT1 bonds were written down to zero in 2020; Ballarpur Industries’ rating change impacted Taurus Mutual Fund's debt fund NAVs (2017); Essel Group's delay in repayment to debt MFs holding fixed maturity plans (2019) caused a scare. Lesson: Selection and constant scrutiny of borrowers is necessary

Regulatory Response To These Events

Side-Pocketing

SEBI allowed funds to segregate "bad assets" so new investors don't buy into bad debt and existing investors can eventually recover money if the bad debt pays up.

Risk-o-Meter

Introduction of the "Potential Risk Class (PRC) Matrix" to clearly show maximum interest rate risk and credit risk a fund can take.

Now that we have learnt a bit more about debt mutual funds, we look at how this translates into decision making for investors in Part III of our Series.

Disclaimer

The information provided in this discussion is strictly for educational and informational purposes and does not constitute professional financial, investment, legal, or tax advice. Mutual fund investments are subject to market risks, including the potential loss of principal, and past performance is not a reliable indicator of future results. All specific fund names, historical events, or financial metrics mentioned are for illustrative purposes only and should not be construed as recommendations to buy or sell any security. You are strongly advised to consult with a Mutual Fund Distributor or a SEBI-registered investment advisor or a qualified financial planner to assess your specific risk profile, tax bracket, and financial goals before making any investment decisions.