Debt funds need to beat FDs for MFs to be sahi

Despite many years of existence and their tax efficiency, debt funds have lagged in the race

There has always been something about the bank deposit. The friendly neighbourhood bank provides safety, security and convenience, and has been the traditional safe haven for investors looking for fixed returns. A few years ago, with demonetisation and the ‘Mutual Funds Sahi Hai’ campaign, investors started exploring alternative debt investment avenues in debt mutual funds. And why not, because with the benefit of liquidity and significant tax efficiency due to long-term capital gains and indexation, debt funds are an obvious go-to product.

As we stand today, the numbers don’t tell a great story about the success of debt funds as a retail product. As of December 2018, there are only 1.12 crore folios of retail and HNI (high net worth) investors in debt funds, with a total asset base of ₹4 lakh-crore. If you narrow this to retail, or investments under ₹5 lakh, the numbers are worse — 98 lakh folios totalling to just ₹85,000 crore. Compare this with the huge base of bank fixed deposits and small savings schemes, and the opportunity is immense. Despite so many years of existence and the obvious benefit of tax efficiency, why have debt funds lagged in the race? I believe two factors are at play — lack of awareness of risks, and the perceived unpredictability of returns.

Gauging risks

Awareness of the risks carried by debt MFs is oddly lower than those in the equity category. The debt-fund landscape has a wide range of categories, and most investors would struggle to identify what fits what purpose in their portfolio. Compare this with equity, where investors know the difference between large- and small-cap risks, and now can digest a 20 per cent fall in small-caps more maturely.

While deposits have always been perceived as a risk-free product, all fixed income carries one or both of two risks — interest-rate and credit risk. Risk that is unknown appears like a black box, but risk that is understood, as it is in equities, can be digested and mitigated. Interest-rate risk, for instance, can be reduced with funds investing in shorter maturity papers, and credit risk, by investing in only AAA rated bonds, which have a good track record of servicing their debt. A perception that debt-fund returns are not predictable is also a missing link in the popularity of debt funds, because deposits provide tremendous predictability over their chosen tenure. The three-year returns in short-term funds has ranged between 5 and 12 per cent on average; in credit-risk funds between 7 and 13 per cent%; and in income funds between 2 and 14 per cent.

The daily mark-to-market in cases of sharp interest moves can also create periods of negative returns, which are difficult for thedeposit investor to digest. The best way to address this is to talk to investors about the risks of duration, and focus on low-duration funds where the return variability is low. Compared with the above funds, the three-year returns in low-duration funds are in a much tighter band — 6-8 per cent. Investors should also aggressively consider close-ended solutions such as Fixed Maturity Plans, where the likelihood of certainty is much higher and the portfolio is well known.

Need to evolve

Debt funds as a category should, and will, see innovation. For instance, target maturity debt funds offer defined maturity and high-return predictability for fixed time horizons. They are a large emerging category in global markets, particularly for retirement planning.

The industry, advisors as well as investors cannot afford to ignore the opportunity and the need to get debt funds right. For investors, know that the liquidity and taxation profile is more favourable than traditional options. Risks exist, but minimise them with the assistance of a sound advisor, and focus on getting the basics right.

One simple strategy that can alleviate many challenges is to match the maturity of the fund with the time horizon of the investment. If you are investing for three years, pick a fund with an average maturity of three years, so that over the time horizon, there is higher return predictability. With credit, while there has been a lot of conversation in the past few months because of the number of credit-related news, know that like in equities, higher yields carry higher risks. Downgrades are part of the game, but holding credit funds through their three-year tenure — if you have the risk tolerance — can has yielded reasonable results. If you still feel nervous about credit risk, settle for the lower yield in a AAA rated fund.

While equity is an important growth asset class, debt is a large and core part of the portfolio, and a basic need of every investor and saver. For MF to be really sahi, debt funds need to win.

The writer is Chief Executive Officer of Edelweiss Asset Management

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