Should you avoid debt funds altogether?

The total debt fund AUM is approximately Rs13,50,000cr, which is nearly 51% of the overall AUM.

September 25, 2019 7:36 IST | India Infoline News Service
Debt Fund
With the recent spate of debt defaults by issuers like IL&FS, Dewan Housing, Cox & Kings and Altico, the debate is back to whether investors should commit money into debt funds. Debt funds are all about safety and liquidity and in that sense there are two extremes. At one end there are the large numbers of better managed income and G-Sec funds where the principal factor is still the movement in rates. At the other end, are the credit risk funds, where there is a serious risk of default and also of liquidity. The truth obviously lies somewhere in between.
Credit risk funds with good portfolios have still performed
If you were to browse through the top-5 credit risk funds on 1 year returns, it is still impressive. For example, the credit risk funds of IDFC, Kotak, ICICI Pru and HDFC have returned over 9% in the last one year. But, few credit risk funds of UTI, INVESCO and DSP have given negative returns. Of course, the worst performer has been BOI AXA Credit Risk Fund which has given (-47%) in the last 1 year and (-25%) in the last 2 years. That is a clear case of over-concentration in toxic debt.
Debt funds are not just about credit risk funds
Over the last 2 years, the entire debt fund segment has got equated with credit risk funds. The exposure to high risk debt is very high only in case of a handful of fund categories. It is these funds that you need to be cautious.
The total debt fund AUM is approximately Rs13,50,000cr, which is nearly 51% of the overall AUM. The total exposure of debt funds to the bonds issued by NBFCs and HFCs is around Rs310,000cr, sharply lower than Rs380,000cr in the middle of 2018. Debt fund experts believe that the fall in AUM and the write-offs would cover a majority of the stressed assets. The remaining debt of NBFCs and HFCs from established names may not pose a credit risk.
There are 2 things to remember. Firstly, debt funds are not only about credit risk funds, with a complete gamut ranging from liquid funds to long duration funds. Credit risk funds are just one category. Secondly, most of the credit risk pain may have already been written off. Also, the exposure to sub-AAA debt varies across debt fund categories.
Data Source: Morningstar
This is the chart that investors should really look at. If you are looking at low risk and liquidity then you must be at the left-end of the chart. If you are a high risk investor, then you can afford to move towards the right end of the chart.
How should investors approach debt funds?
Obviously the answer is not to shun debt funds altogether. A debt fund has a key role to play in your overall portfolio and also in your financial plan as it proffers safety and stability to your portfolio. Here are five points for investors to keep in mind.
Start with your long term goals in mind and work out debt allocation. Higher risk categories like credit risk funds, floating rate funds or modified duration funds should not be more than 15-20% of your debt portfolio. Stick to top performers only. 
  • If you have milestone payments coming up as part of your goals, then you must strictly remain on the left side of the above chart. The right side is clearly not for you.
  • Debt funds are a lot more tax-efficient and flexible compared to bank FDs so don’t be in a hurry to exit debt funds for bank FDs. Be discerning about the type of debt funds.
  • What makes debt funds attractive to investors is elasticity to rate cuts. For example, a 1-2% fall in rates can enhance returns on government bond funds by 4-5%.
  • Finally, remember that debt funds are not risk free. Credit risk funds have credit risk and government bond funds have interest rate risk. Apart from returns look at the portfolio mix too.
To answer the question, you don’t need to be in a hurry to exit debt funds altogether. It is just time to calibrate your debt fund portfolio.

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