Selecting the right debt fund

For all their similarities, debt funds are not all alike.  Ideally, to identify the right fund to invest into, one should have a thorough understanding of the risks involved in investing in debt funds and how to assess these risks.  This becomes all the more important because, in my opinion, the potential heartburn from selecting an inappropriate debt fund can be far more than in the case of any other category of funds.  While, over time, I hope to devote posts to talking about these risks and how to assess them, in this post, I’d like to present a straightforward way to understand the types of debt funds and their suitability.

Let me start by suggesting that debt funds can be grouped into three broad categories:

Category A: Closed-end schemes

Category B: Open-end schemes where the fund manager can make significant changes to the average maturity

Category C: Open-end schemes where the fund manager intends to keep the average maturity within a narrow band

This is not a textbook classification but I believe it is the best way to assess the suitability of a fund. To facilitate understanding as to which funds fit in what category, I will be linking these with the categories put forth by Value Research.  You may notice a certain ambiguity to the definitions (what, for instance would ‘significant’ or ‘narrow’ mean?)- but interpreting these will be less relevant once I link these to the categories of Value Research.

Let me now elaborate on these categories.

Category A : This is really the same as Value Research’s category: Fixed Maturity Plans.  Like deposits, these funds have a fixed tenure. Amongst all categories, these carry the highest level of predictability as to the returns one can expect. The returns on such funds virtually mirror the returns of the underlying debt instruments. This is a key reason why a number of advisors strongly encourage their clients to invest in these funds.

On the flip side, these funds typically carry severe restrictions in case we need to withdraw before the term of the fund. It is possible we may not even be able to do so.  For this reason, these are best suited for investors with crystal clarity about the time they would like to stay invested.  The right fund is one whose tenure matches one’s own investment time horizon.

Do bear in mind that at the time of investing, we do not know the exact composition of the portfolio of the fund. Once the portfolio is disclosed, if we don’t like what we see, it may not be easy to walk out. It, therefore, becomes important to get as much clarity as we can, about what the portfolio will look like, before we invest our money. Additionally, at the end of their tenure, these are compulsorily redeemed- we cannot defer exiting the fund beyond that time.  This is important because taxes, if any, become due the moment we redeem an investment.

Category B: This would include funds in the following categories of Value Research: Income, Gilt-Medium and Long Term, and Gilt-Short Term. 

These funds are best suited for investors who are looking for the highest returns (among debt funds) and are willing to take higher risk, and to time their entry into, and exit from these funds.  To put it differently, these funds are an acquired taste- these are not for everyone. These carry the highest level of unpredictability as to the returns one can expect.  Historical 1 year returns show that it is not uncommon to see a double-digit difference between the returns of the best performing and the worst performing funds, particularly in the Income and Gilt-Medium and Long Term categories.  In the turbulence of mid-July to mid-August, 2013, the worst performing funds in each of these three categories had lost between 5% and 12%. 

Category C: This would include funds in the following categories of Value Research: Liquid, Ultra Short Term, and Short Term.  Like the funds in Category B, being open-end schemes, these allow one to defer one’s exit (and taxes) for as long as one wants to.  But because of their targeted maturity being more narrowly defined than those in Category B, there is a higher level of predictability to their returns.

Here is how I look at their suitability, relative to comparable bank deposits:

• For someone with an investment horizon of up to 3 months, funds in the Liquid category can be a good choice and, in my opinion, can be expected to give better returns than a bank deposit. 
• For someone with a investment horizon of over 3 months and less than a year, funds in the  Ultra Short Term category can be a good choice and in my opinion, can be expected to give better returns than a bank deposit. 
• For someone with a time horizon of over a year but less than 3 years, I would recommend going for a bank deposit rather than a debt fund. 
• For someone with a time horizon of over 3 years, and with no taxable income or who is in the lowest tax bracket, I would again recommend a bank deposit over a debt fund. 
• For someone with a time horizon of over 3 years, and in the higher tax brackets, funds in the Ultra Short Term and Short Term categories can be a good choice and can be expected to give better returns than a bank deposit, after adjusting for taxes.

To take all of this further towards deciding which specific fund to select, as I mentioned at the start, it would help to understand the risks involved in investing in debt funds and how to assess these risks.  I hope to dwell on these in detail in future posts.  For now, I would like to close with a mention of one important indicator to consider while selecting a fund: the expense ratio. 

The expense ratio tells us how much is deducted as expenses by the fund house from whatever they have earned from their investments.  While this is an important indicator across all kinds of funds, it is particularly crucial in the context of debt funds.  Here’s one way to look at this: if two funds follow identical strategies and take identical risks, the fund with the lesser expense ratio will give better returns.  A note of caution: As important as this is, in my opinion, there is generally a lack of transparency regarding this indicator across the mutual fund industry.  Though, in all fairness, Value Research and Morningstar provide this indicator for most funds, most fund houses don’t disclose this in their monthly fact sheets.

For that reason, personally, I focus only on funds where the expense ratio is disclosed transparently, month after month, in their fact sheets.

A wake-up call for the mutual fund industry

I refer to the Budget proposals made yesterday, specifically the ones to amend the way gains from debt funds will be taxed.

I guess the objective would have been to plug an area that was impacting tax collections.  One has to admire how perfect a choice this is- high on impact, and low on collateral damage, with some potentially interesting side effects to boot.  For me, the most interesting of these would be the impact this has on the mutual fund industry.

Mutual funds were originally envisioned as a means to help retail investors build long-term wealth. Yet, over the years, the industry did little to justify its existence for this purpose. It chased corporates and high net-worth individuals, ignoring the masses.  It unabashedly marketed FMPs as a way to get around the taxes that other debt instruments would involve.  In short, the industry constantly looked around for easy, short-term profitability. 

Sure, exceptions were (and are) there, but as a whole, the industry has taken little pride in the nobility of the purpose for which it existed.  If the Budget proposals do become a reality, this will, in my opinion, be the biggest wake-up call the industry has ever had.

Are debt funds still worth investing into?

Short answer: Yes, but…

In the first post of this blog, a couple of months ago, I mentioned three categories of investors for whom there was a compelling case to consider investing in mutual funds.  Yesterday’s Budget proposals for a change in taxation of gains from debt funds don’t negate the points I made in that post.  However, for investors with a proposed investment tenure of less than 3 years, the case to consider a debt fund is now considerably weakened. 

Some time ago, I undertook a study that covered the period 2007-2013, over which I compared the returns from debt funds with a cumulative term deposit with State Bank of India.  I looked at the calendar year returns and at the rolling 2 year (calendar year) returns.  The fund data was taken from Value Research.  No exit loads were applied. The data covered 370 debt funds, of which 153 were in existence in 2007 (and for which data was available for each year since).  Here are some findings:

1 year returns:

The best calendar year in terms of the number of funds outperforming the deposit was 2008, when 81% of the funds did so.  The worst year was 2009 when 6% of the funds did so.

Of the 153 funds in existence since 2007, no fund beat the return from the deposit in all 7 calendar years.  3 funds outperformed the deposit in 6 of the 7 years, while another 27 did so in 5 of the 7 years.  There were 58 funds which outperformed the deposit in 2 years or less (including 6 funds which did not surpass the returns from the deposit in any single calendar year.)

2 year returns:

The best two-year period in terms of number of funds outperforming the deposit was 2011-12, when 78% of the funds did so.  The worst two-year period was 2009-10 when 1% of the funds beat the returns from the deposit.

No fund surpassed the returns from the deposit over all 6 two-year periods.  2 funds outperformed the deposit in 5 of the 6 two-year periods while 18 funds did so in 4 of the 6 two-year periods.  The vast majority of the funds outperformed the deposit half the time or less.  14 funds did not beat the returns from the deposit in any two-year period.

There was no pattern that I could see across these numbers linking funds having a similar average maturity or credit quality or strategy. Looking at these numbers, I am inclined to believe that without the advantage of tax breaks, investing in a debt fund, hoping to beat the returns from a 1 year deposit or a 2 year deposit is quite like a shot in the dark.  I am also inclined to believe that for someone in the higher tax brackets, there is a case to consider allocating more to equity funds.  After all, the return required to outperform a deposit or a debt fund just went down. But maybe that’s a discussion best left for another time.  For now, consider it as food for thought.

Do you really need to invest in mutual funds?

If you fall into one of these three categories of investors, there is a cogent case for you to consider investing in mutual funds.

• You are presently working but will retire at some time in the future.
• You are retired and dependent on the income from your investments.
• You pay high taxes.

Let me elaborate on each of these scenarios.

Presently working, planning to retire:

Barring a miniscule minority, most of us who work, are dependent on the income from our profession. When we retire from our profession, we will be fully dependent on the income that we can passively generate from our investments. Whether we realize it or not, a key purpose of our working life is to acquire adequate wealth to passively generate the income we desire, post-retirement.

Let’s assume for a moment that one were to retire at the age of 60. If medical science continues to progress the way it has, there is a high chance of living up to the age of 90 or beyond. That means that the wealth that one has at the start of one’s retirement needs to see one through a period of 30 years.

The evidence suggests that for a lot of Indians working today, getting to that level of wealth will need them to earn a return on their current investments that is higher than what bank deposits offer. That limits the choice of investment options to stocks and real estate. Without getting into a debate at this point over which is a better choice, let me suggest that directly investing into both these options requires the kind of expertise which is beyond the capability of most investors. That’s where mutual funds come in. Currently there may be no real estate funds in India but there are a wide variety of equity funds available. Yes, building and nurturing a portfolio of equity funds, too, calls call for some degree of expertise but that is far less than what is called for building and nurturing a portfolio of stocks. Furthermore, there are many more financial advisors who possess and offer the expertise for the former, as compared to those who possess and offer the expertise for the latter.

Retired:

As mentioned earlier, individuals in this stage don’t have the luxury of being able to take much risk on their investments. Coupled with the need for assurance of return, such investors tend to choose debt instruments. These instruments carry one significant limitation: you are stuck with receiving a fixed amount for the entire tenure of the investment.

Why is that a drawback? Our expenses do not remain fixed: these tend to go up with inflation. Retired individuals, thus, need an investment option which can either generate the income they need (after adjusting for inflation), or give them the flexibility to draw upon their investment principal, as and when necessary. Open-end debt funds score on the second count. Combine these with a slice of equity funds, and you have a portfolio that could score on both counts.

The need for tax efficiency

To the extent that our money needs to be in debt instruments, we have the choice to opt for debt instruments like bank deposits, Post Office schemes, bonds, and the PPF, or go for debt funds. For individuals paying higher taxes, PPF and debt funds represent more tax efficient choices. The PPF is unique in that it offers both a tax rebate at the time of investment, and its income is completely tax free. It has two major drawbacks, though. There are restrictions on the amount you can invest, and it is not very liquid.

In this backdrop, open-end debt funds present an interesting alternative. These are highly liquid, and have no restrictions on what you can invest. Unlike other debt instruments, there is no assurance of ‘fixed income.’ There are debt funds, though, which have a high degree of predictability as to the return these will generate.

On tax efficiency, open-end debt funds score lower than the PPF. But relative to any other debt instrument these offer far greater tax efficiency. The tax efficiency comes in two forms: the rate of tax, and the ability to defer paying taxes until we withdraw.

I hope to further expand upon some of these issues in the weeks ahead. Nonetheless, feel free to email me if you have any questions or feedback on this post.