Why debt mutual funds are good investments in volatile markets

The last 1 year was a volatile period for the stock market. Though the Nifty is around 300 points or 3% higher on a year on year basis (as on February 13, 2019), the 52 week high and low ranged from 11,760 to 9,950 (deviation of nearly 20%). The near term outlook on the market is a little uncertain due to a number of global risk factors. There are concerns of earnings slowdown in the US, economic slowdown in China, US / China trade wars and the global consequences thereof, uncertainty about the form of Brexit, crude price outlook etc. Among local factors, the biggest is the political risk, with the possibility of hung Parliament after the upcoming Lok Sabha elections weighing on foreign institutional investors. Though the market has been range bound for the last few months, in our view, volatility is likely to stay in the near term.

Asset allocation is of utmost importance for investors to deal with market volatility. Asset allocation ensures liquidity, optimizes portfolio risk and provides stability, and helps investors achieve their short term, medium term and long term financial goals, irrespective of market conditions. From an asset allocation perspective, debt mutual funds are good investment options in volatile markets. The primary investment objective in debt funds is income and risk limitation. In this blog post, we will discuss why debt mutual funds are good investment options in volatile markets and which debt funds should investors consider in such conditions.

What are debt mutual funds?

Debt mutual funds are mutual fund schemes which invest in debt and money market securities like commercial papers, certificates of deposits, non-convertible debentures, treasury bills, Government securities (G-Secs) etc. These securities pay a fixed interest rate (also known as coupon rate) to investors through the tenor of the security and the face value (principal amount) upon maturity. Since these securities are contractually obligated to pay interest, the risk of these investments are much lower than equity, where the management is under no obligation to pay dividends. Furthermore, if you hold a debt security to maturity, the issuer is obligated to pay you the face value on maturity (assuming no default), unlike stocks whose prices are market driven.

What are the risks in debt mutual funds?

Investors should note however that, debt mutual funds are also subject to market risks and cannot give assured or risk free returns. Debt and money market securities trade in the capital market and their market prices are subject to interest rate and credit risk. If interest rates rise, prices of debt securities will fall and vice versa. Similarly, if the credit rating of a security declines, its price will fall and vice versa. Unless you hold debt or money market security till maturity, you will be subject to these risks. But since debt securities are contractually obligated to pay coupons (interest) and face value (principal), in absence of default the risk in debt funds is much lower than equity funds. In the last one year short and low duration debt funds gave 6.5 to 7% average returns, while most equity fund categories gave negative returns.

Why are debt mutual funds suitable in current market (volatile) conditions?

• A company must meet its debt obligations first before meeting obligations towards shareholders. In other words, if a company has issued both bonds and shares, it has to make coupon payments to its bond holders, then pay taxes and then it can decide how much of profit after taxes, it will pay as dividends to shareholders or re-invest in the business, which can result in capital appreciation for shareholders. Naturally, risk for debt investors is much lower compared to equity investors. In an uncertain economic environment, when visibility on earnings growth is not clear, debt funds are superior investment choices in near to medium term.


• Debt funds are much less volatile compared to equity funds. The average standard deviation of returns of short duration debt mutual funds is only 1.6%, whereas the average standard deviations of large cap equity funds is 14.3% and that of multi-cap equity funds is 15.3% (source: Value Research); volatility of mid and small cap funds are even higher). In volatile markets, debt mutual funds will provide income and stability to investment portfolio.


• Bond yields have been rising from mid 2017 onwards till October 2018, after which the trend reversed. Bond yields saw another spike in January 2019 and have declined since then. However, the 10 year Government Bond yield is at 7.3% (even after falling from the highs over the last few months). You can lock in these fairly high yields by investing in accrual debt mutual funds. These funds focus on earning interest incomes from the coupons paid by the debt securities of the portfolio over the maturity of the security (hold to maturity strategy).


• Economists believe that US interest rates are approaching the peak. The US Federal Reserve’s monetary policy indicates a pause in rate hikes. This will cause interest rates and bond yields to soften and bond prices to rise. The Fed’s interest rate policy will have ramifications on interest rates around the globe, towards a more accommodative interest rate regime. In our country, the RBI cut the repo rate by 25 bps and RBI’s monetary policy shows a shift from inflation to growth concerns. As per the latest data, CPI inflation cooled to 2.05%, the lowest in the last 19 months; this will give room for more accommodation in the interest rate regime of the RBI. With expectations of lower interest rate and bond yields in the future, debt mutual fund investors can gain from capital appreciation since bond prices rises when interest rate falls.


• Debt mutual funds, held for a period of 3 years or more, are much more tax friendly compared to traditional fixed income investment options in India like Bank FDs and Government Small Savings Schemes. Bank FD interest is taxed as per the income tax rate of the investor, while long term (held for more than 3 years) debt fund capital gains are taxed at 20%, after allowing for indexation benefits. Indexation benefits reduce the tax obligation of the investors substantially.

Which debt mutual funds should you invest in the current economic climate?

2017 and 2018 were difficult years for the bond markets, but the conditions seem to be turning favorable as discussed above. In 2018 very short duration funds like overnight funds, liquid funds etc. were the top performing debt mutual fund categories. But with expectations of further easing in interest rates, low to medium duration funds can outperform in the near to medium term due to price appreciation of bonds (with yield declines). The yield curve (term structure of interest rates of bonds of different maturities) was much flatter 6 months ago, but it has been steepening since then and longer duration bonds look better from a risk return trade-off standpoint.

However, you should remember that the inflexion in the yield trajectory took place just 3 – 4 months back. Given the backdrop of global risk factors discussed at the beginning of this post, there are still significant concerns in our view about the RupeeDollar exchange rate, which can have an impact on bond yields. Therefore, for investors with conservative or moderately conservative risk appetites, low duration and short duration debt mutual funds are more suitable investment choices compared to long duration or even medium duration debt mutual funds. Investors should note that, longer the duration of a debt fund, higher is the interest rate risk.

Debt mutual funds from SBI Mutual Fund stable suitable for investors

• SBI Magnum Ultra Short Duration Fund: This is an ultra-short duration debt mutual fund investing in money market. The scheme has over Rs 5,300 Crores of assets under management, with an expense ratio of 0.38%. There is no exit load. The scheme gave 8.2% return in the last 1 year. The modified duration of this scheme portfolio is just 0.39 years and so, the interest rate risk is very limited. This is an excellent investment option for parking your surplus funds for up to a year.


• SBI Magnum Low Duration Fund: This is one of the top performing funds (among Top 3) in the low duration debt fund category. The scheme gave 7.8% return in the last 1 year. The modified duration of the scheme portfolio is 0.6 years and the yield to maturity is 8.25%. Expense ratio is just 0.46%. There is no exit load in this scheme. This scheme is a great investment option for parking your funds for a year or so.


• SBI Short Term Debt Fund: This is another good debt fund from SBI MF stable. The fund gave 6.3% return in the last one year and 2.4% return in just last 3 months, benefiting from the softening yields. There is no exit load. The modified duration of the scheme portfolio is 1.88 years. This is a good fixed income investment option for investors who have 2 – 3 years investment horizon. Investors may want to factor in the tax benefit enjoyed by debt mutual fund investors over 3 years plus investment tenors, when planning their investment in this fund.

Conclusion

In this blog post, we discussed why debt mutual funds are good investment options in the current volatile market conditions. Volatility may last for some time and therefore, you must pay attention towards your asset allocation. Debt mutual funds will provide stability and also income to your investment portfolio in these volatile conditions. Debt mutual funds are also much more tax efficient than traditional fixed income investments. In this post, we also discussed the types of debt mutual funds, which will be suitable for you in current economic conditions after taking into considerations the local and global risk factors; ultra-short duration fund, low duration fund and short duration funds have low interest risk and can benefit from high yields. We discussed with you 3 funds from the SBI Mutual Fund stable which can be good investment options. You should discuss with your financial advisor, if these schemes are suitable for your investment needs.