The Franklin Templeton crisis has brought to light many instances of mis-selling and mis-buying in debt mutual funds (MFs), where many folks seem to have signed up for these products without understanding their true nature.
Here are specific situations in which you should avoid investing in debt funds.
Securing the principal
If the top attribute you look for in a debt investment is your principal remaining intact, then debt MFs aren’t for you. Unlike deposits or small savings schemes, debt MFs are market-linked vehicles that pass on not just interest receipts, but also capital gains or losses on the bonds they own, to you.
Some categories of debt funds are highly prone to capital losses. Funds which invest in longer-dated government securities or bonds fall in this category.
Gilt funds made 12-13% NAV losses between January 2009 and 2010 as interest rates rose. Funds that invest in lower- rated corporate bonds (credit risk funds) can hit you with substantial losses, if the issuers, whose bonds they hold, default or get downgraded.
In the recent past, we’ve seen some credit risk funds taking 20-30% NAV knocks on such write-offs. Even safer categories of debt funds such as ultra-short, short, low-duration or liquid funds are not wholly loss-proof. In the past, liquid, short and low duration funds have taken NAV hits on commercial paper from issuers who got downgraded.
Liquid funds, deemed the safest, experienced a brief period of negative returns in March after big pullouts from the money market-battered bond prices.
So, if you have zero tolerance for capital losses, it is best to steer clear of debt funds and stick to bank deposits or post office schemes instead.
Predictable income
With a bank deposit or a Sundaram Finance FD it is possible to know exactly at the time of investing, the interest income you’re likely to receive every year. Such planning is impossible with debt funds because of the high variability in returns.
Some debt fund categories are more volatile than others. For instance, gilt funds, which delivered a 11% return in 2019, earned just 2% in 2017. Credit risk funds, which surprised investors with 9-11% returns between 2011 and 2016, have averaged a nil return in 2019 after a bunch of debt write-offs.
But even debt fund categories that don’t take on very high credit or duration risks tend to deliver volatile returns. In the last ten years, corporate bond funds have seen their annual returns swing from 5.5% to 11% and banking/PSU funds from 5.9% to 10%. Short duration and liquid funds have delivered between 5% and 10%. Knowing which category of debt fund will deliver a good return in the year ahead needs one to make accurate forecasts on interest rate movements and the ability of companies to service their debt. Even star fund managers haven’t been great at this, so it’s a tall task for the retail investor.
Yes, setting up Systematic Withdrawal Plans (SWPs) to receive regular cash flows from debt funds can help you deal with this problem.
But while SWPs smoothen out your cash flows, they don’t change the underlying nature of returns from a debt fund that remain volatile. So, if you are a pensioner, senior citizen or self-employed person looking for high predictability of income, then debt funds aren’t for you.
Preserving wealth
Received a big windfall from an employer/relative that you simply want to protect? Are you a high net worth investor who is looking to preserve the wealth you’ve created for posterity?
If preserving wealth takes priority over growing it, then you have no need to take on the risk of capital losses or bond market volatility with debt MFs.
Such investors have the choice of alternative debt investments that offer reasonable returns with a capital guarantee such as GOI 7.75% taxable bonds, National Savings Certificates (6.8%) or Kisan Vikas Patra (6.9%) which lock in your money for 5-9 years but promise to keep your capital intact. The returns are comparable to debt funds too.
No tax considerations
Tax-efficiency is one of the main arguments offered for signing up for debt funds.
Your interest receipts from bank FDs, GOI bonds and post office schemes are treated as income and taxed at your income tax slab rate. But returns on the growth options of debt funds are treated as capital gains. This leads to two tax advantages.
One, when you hold a debt fund for less than 3 years and set up cash flows via SWP, you pay tax only on the ‘return’ part of your withdrawals and not on the entire withdrawal amount.
Two, if you hold debt funds for over 3 years, the capital gains are taxed at a flat 20% after adjusting for indexed costs, effectively allowing you to pay tax only on the returns earned over inflation.
This leads to substantially better post-tax returns on debt funds compared to safer alternatives such as bank or post office deposits.
However, this tax arbitrage matters mainly to folks in the 20-30% tax brackets. For those in the 10% bracket or with no tax liability, the tax efficiency may not be incentive enough to take on higher risks.
