Children look at a map of the Alice in Wonderland Maze at Walt Disney Co.’s Shanghai Disneyland theme park in Shanghai, China. (Photographer: Qilai Shen/Bloomberg)

The Mutual Fund Show: A Step-By-Step Guide To Unravel The Debt Fund Puzzle

Debt mutual funds are akin to a maze and choosing a scheme often becomes more of a riddle which only a handful of investors are adept at solving considering all the types, tenures, yields and credibility.

“When you lose 25 percent in an equity fund, you get upset but it’s not a rude shock! But in debt perhaps because we don’t understand that its risky and what the risks are, it becomes a lot scarier when you lose money,” said Chief Executive Officer Radhika Gupta.

Investors must match their investment horizon to the tenure of the paper, Gupta said on BloombergQuint’s weekly series The Mutual Fund Show. “Investors should go for short-duration bonds when it is a high interest rate scenario and should go for long-duration bonds during a down interest rate cycle.”

Dhawal Dalal, chief investment officer (fixed income) at the asset manager, offered a step-by-step guide to pick the right debt fund.

“Debt mutual funds should be part of any investor’s asset allocation,” he said. “Once a suitable debt fund category is identified, investments through systematic investment plan route in debt funds will help achieve financial goals and reduce volatility in returns.”

Also read: Inflows Into Equity Mutual Funds Fall For Fourth Straight Month

Watch the full episode here:

Also read: The Mutual Fund Show: Why Nimesh Shah Has A Boring Portfolio 

Here are the edited excerpts of the interview:

What are debt funds?

Dhawal Dalal: Debt funds are fixed income funds that invest in safe assets wherein you invest at Rs 100, earn your interest and get you Rs 100 back on maturity. Various kind of instruments are available on investments. Broadly money market instruments which include commercial papers, certificate of deposits and treasury bills. On debt side, we have non-convertible debentures, government bonds and other kind of instruments. Depending on investors’ appetite and your duration of investment, you could consider either investing in short-term fund which typically invest in money market instruments, or you could consider investing in funds like dynamic bond funds which typically invest in longer duration assets.

If I am investing Rs 10,000 in your debt fund, what would your fund do with it? How will you generate returns for me as an investor?

Radhika Gupta: Debt funds invest in bonds. They invest in coupon bearing or non-coupon bearing bond. They invest in bonds of government of India, public sector enterprises, bonds of corporate houses. Those bonds can be three to six month bonds or 15-20 year bonds. But it is a pooled vehicle which is investing in some kind of bond. Just as equity funds are investing in stocks of underlying companies.

The returns on coupon that come or the return which may come in out of appreciation of this bonds because of purchase price being favourable essentially generate the return for me as an investor.

Dhawal Dalal: Whether it is appreciation or marginal depreciation depending on the underlying movement in bond yields which we have seen in the last two years. It is part of valuation of underlying assets which gets translated into daily net asset value. The investors returns are being calculated based on the movement of underlying NAV.

In the debt market, an AMC is trying to buy X amount of bonds. How is it that each of those funds which is housed by experts who know how to do these be able to get those bonds at lower prices? Somebody has to pay higher prices and therefore the returns will get mitigated. So, they are not risk free.

Dhawal Dalal: Let me clarify how the process of auction takes place. SEBI has allowed the electronic bidding platform and has made it mandatory for large investors who want to borrow money to approach electronic bidding platform. For a company who wants to borrow money will approach electronic bidding platform and ask investors to bid. Various investors like us who are interested in that asset will bid at our level. Based on the electronic auction, the cut offs are decided. For me to bid, I need to have money in my fund at that point of time. Suppose after the cut off, two days later, I get large amount of money as an inflow then I don’t have access to that bond. For me to buy that bond, I will have to approach secondary market for it. At that point of time, depending on the demand and supply and market levels the price of the bond will either be higher or lower.

What is a duration risk?

Radhika Gupta: Duration risk exists in all kinds of bonds. Bonds have a particular maturity. They have a price. As interest rates move up and down, the price of underlying bond fluctuates. If the bond has a longer tenure, it has a higher duration. If it is a five-year bond, then it will have higher duration than a one-year bond, which means that when interest rates move it is more susceptible to large changes. The risk is mark-to-market. If you bought the bond and went to sleep for five years and woke up after five years, then you are good. But in the middle, there will be risk. When you are buying longer duration bonds, in the middle there will be risk. But if you woke up after five years, you will be fine.

How do I find that this fund has higher duration?

Dhawal Dalal: It is available on fund factsheet. It talks about weighted average maturity of the scheme as well as duration of the scheme. When interest rates are trending higher, as you can see from economic cycle and the RBI’s rate cycle, investors should consider investing in low-duration fund and high quality when rate cycle is on up move. More important is after the recent categorisation by SEBI, investors can know which scheme is supposed to maintain what kind of duration bucket. It is a very useful information and it is designed to ensure that investors don’t get into a wrong fund at the wrong time.

When an investor believes that we are on an interest rates upcycle and downcycle, what kind of fund does he/she choose?

Dhawal Dalal: In an interest rate upcycle, you should consider investing in funds with low duration. For that you have liquid fund, ultra-short-term fund and low-duration fund whose duration is less than a year. That is scheme for considering when the interest rates cycle is on an upmove. While interest rate cycle is on downside, investors are better off investing in long-duration funds. For that, you have medium-term funds, medium- to-long-duration fund and long-duration fund as specified by SEBI.

What is credit risk?

Radhika Gupta: Credit risk refers to the fact that you have different kinds of corporates with different credit ratings with AA and AAA. There are funds which are government of India-only paper. There are funds which are credit risk funds which have lower credit-rated paper. The worst the borrower, the higher the yield. Like in small caps, smaller the company, higher the growth and more the risk.

How does one mitigate the credit risk?

Radhika Gupta: You have to know what you are going in for. Just like funds give their duration profile, they give their credit profile. So, you can see on a fund factsheet how much of fund is AAA, AA and A. Again, SEBI has done categorisation to some extent. You have G-sec fund which are 100 percent government bonds. You have another extreme which is credit risk funds. In that, under 65 percent or more, it has to be AA or below. That categorisation is there plus you look at the fund factsheet. If you don’t want to take credit risk, please invest in something which has lots of AAA. If you want credit risk, look for the rating in the fund.

If I want returns which are safest but better than my FD, what category should I choose? If I am willing to take little bit of risk, what kind of category do I choose?

Dhawal Dalal: In the current environment, investors are well advised to remain at the short end of the duration curve. In that regard, liquid, ultra-short, low duration are some of the schemes that investors are well advised to consider for somebody seeking better than FD return with an element of safety. I am managing fixed income fund, but people should consider investing in arbitrage fund which are giving significant amount of stable return without any kind of credit risk in their portfolio. Although they are equity fund, they are being managed like fixed income fund. Arbitrage fund, liquid fund, ultra-short-term fund and low duration fund are some of the schemes that investors should consider now. As the RBI has embarked on a rate-cutting cycle and the inflation is subdued worldwide, at some point of time we will see some kind of decline in bond yields. At that point of time, investors could consider investing in dynamic bond funds.

The G-sec funds five-year return have been 9 percent, one-year return has been 8 percent and some of short-term funds have underperformed in last one year. Is this the benchmark return which people can expect or this may vary?

Dhawal Dalal: The government bonds are a function of the underlying RBI rate movement as well as bond yields. Short-term funds have been a very preferred investment avenue for a lot of retail investors, but they have been badgered recently because of credit events. Next time, the short-term fund could have different return profile. So, it goes up and down. I would advice investors to remain up to short-term funds, particularly retail investors. Don’t venture into it unless we have a decline in bond yields.