Debt funds can beat fixed deposits on post-tax returns, says expert

Investors in debt mutual funds are a worried lot. With fixed maturity plans (FMPs) and credit risk funds witnessing net outflows of Rs 17,644 crore and Rs 1,253 crore respectively in April, there are signs of nervousness. As a leading distributor says: “I get calls every day, even from seasoned high networth individuals, wanting to exit their debt funds. I try to talk them out of doing so by talking about tax benefits and better returns. But it is a tough call in such times.” 

And it is. With the defaults of Infrastructure Leasing and Financial Services companies, delays in payment by Essel and Reliance groups, and the dreaded rating downgrades happening regularly, debt fund managers are on their toes. Worse still, Rs 1.3 trillion worth of non-banking financial companies’ (NBFCs) papers are coming up for redemption in the next three months. While fund managers are keeping up a brave face and saying there is nothing to worry about, no one is exactly sure. 

Trouble in FMPs and credit risk funds: In April, FMPs were in the eye of a storm as two fund houses— HDFC and Kotak—failed to fully redeem the money due to investors. While Kotak Mutual Fund (MF) paid out whatever money it had, and promised to pay its investors the balance as and when it received the money from borrowers, HDFC MF rolled over one of its FMPs by a year. These developments have affected investor confidence in FMPs. 

In credit risk funds, the fund manager invests in lower-rated securities to earn extra returns. In the past few years, these funds have attracted significant inflows as they were sold based on high past returns. Now, with so many defaults and downgrades happening, and net asset values (NAVs) of many debt funds getting hit, investors are steering away from this high-risk category. 

Macro-economic stress: One reason for the spate of credit-related episodes is that the economy is slowing down. “Large segments of the economy like infrastructure and manufacturing are not doing well. Consumption too appears to be slowing with fast moving consumer goods (FMCG) companies reporting poorer numbers,” says Nikhil Banerjee, co-founder, Mintwalk. He adds that when the economy is slowing down, companies struggle to return borrowed money. Further, in such an environment companies with poor business and corporate governance models tend to falter. 

Inadequate due diligence: The spate of hits that debt funds have taken has also put a question mark on whether fund managers did their jobs diligently. Many financial advisors now believe that fund managers were blindly chasing yields and did not pay adequate attention to risk.  

Experts say that when investing in a company’s equities, an equity fund manager looks at its fundamentals, such as whether it has a viable business model and generates free cash flows. The same should have been done when investing in a company’s debt papers. “Many companies whose debt papers fund managers invested in did not have any real business activity or operating cash flows,” says Vidya Bala, head of research, Fundsindia.com. She adds that while the promoter’s shares, put up as collateral, may have provided an additional layer of security, fund managers should have still checked whether these companies possessed these two fundamental attributes. Moreover, if money was being invested in poor-quality companies, a collateral of 1.5 times was inadequate. Fund managers also erred by investing in groups where the level of promoter pledging was very high. In case things went wrong, shares would be sold, and their prices would crash, reducing the value of the collateral. This is what has transpired in the case of some of these companies. 

 

Fund managers can also not lay the blame at the doors of credit rating agencies (CRAs). “Mutual funds are supposed to have their own set of analysts and do their checks on companies,” says Banerjee. In the past, the market regulator, the Securities and Exchange Board of India (Sebi), has also urged fund houses to do their due diligence and not go just by ratings.   

Be cautious, but don’t avoid them altogether: While recent events have dented confidence, investors should not avoid debt funds altogether. As Radhika Gupta, chief executive officer, Edelweiss Asset Management says: “It would be a tragedy if recent events turn investors off debt funds. Remember that post-tax returns from debt funds can be better than from fixed deposits.” She adds that besides constantly working on improving their processes for selection of debt instruments, the industry also needs to do a better job of communicating the risks in debt funds, instead of only talking about the potential returns. She adds that one does not witness a similar outcry when equity funds take a hit because investors have been made better aware of their risks. 

Investors, on their part, need to avoid investing in categories like credit risk based only on past returns. They also need to focus on the potential risk in these funds, and whether they have the appetite for it.

As for FMPs, invest in them only to lock in interest rates when they are high and are set to decline. In the current environment, only go for FMPs that invest in gilts and triple-A bonds. “Do not invest in them for double-indexation tax benefit because you can obtain that through an open-end debt fund also,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. He adds that open-end funds offer the additional benefit that you can see the portfolio quality before investing in it. You can also exit if you come across a paper that could potentially default. Bala says that while open-end debt funds can be volatile, you can nullify it by holding on to the fund for your pre-decided horizon.    

At present, retail investors should put the bulk of their money in very short duration funds that do not take either credit or duration risk. They also need to bet on portfolios that are well diversified, so that even if a downgrade or default happens the damage is limited.