If you have been a Debt Fund investor as part of your asset allocation, you might have been a little concerned looking at some fluctuation in NAVs. You would have, either been informed by your fund manager or read it in news that increase in Bond Yields are responsible for it, so what’s the corelation? We will get to that shortly but some basics first.

It is a common misconception among investors that debt instruments and debt funds are 100% stable and safe. The statement may be true if viewed in context of other asset classes, like equity, but not otherwise. The fact is debt or bond markets do have some risks given market dynamics and interdependence of different financial instruments.

Debt instruments carry various kind of risks, such as credit risk, interest rate risk, etc. and can be impacted by changes in macro-economic outlook.

In the recent times we have seen some cases of credit defaults, and winding up of debt schemes overnight, leading to losses and blocked funds of investor, raising questions regarding safety of debt funds. Even if these incidences are considered one off, it’s a fact that debt and bonds are not completely immune to market conditions and macro economic factors.

Currently, the investors are concerned about the sudden fall in NAVs of their debt funds. Bond markets are going through a phase of surging bond yields which has had a negative impact on the bond prices and NAVs of debt mutual funds. So what’s causing this and what’s the strategy to navigate these times…

The reason behind the surge in bond yields…

The Union Budget 2021 focused on pro-growth measures and making structural reforms to get the economy back on track. It provided an extensive spending plan on long-term projects including infrastructure, capex, and healthcare, which comes at a cost of higher fiscal deficit.

The increase in the fiscal deficit target and higher borrowing program the government announced in the union budget has altered the sentiments in bond markets.

The increase in borrowings in the current fiscal year will lead to an increase in supply of government bonds to the extent of Rs 80,000 crore, which might suppress the bond prices, thus causing a spike in yields. Moreover, the higher borrowing target for the next fiscal year will continue to push bond yields higher.

As you may be aware, bond prices and yields are inversely related. A surge in yield will impact bond prices negatively, thus causing a loss to the investors’ value.

Bond yields have already seen an upward bias, In the month of February 2021 alone, we have seen the NAV of debt funds declining up to -3.7% (absolute), thus diminishing investors’ wealth.

Is the rally in bond markets over?

Last 12 months of COVID-19 crisis that led to series of lockdowns, hampering normal economic activities, obstructed business and economic growth. As a measure to fight the crisis, the government on one hand announced a series of salvage packages. On the other, the central bank supported the economy by announcing various liquidity measures, ensured monetary transmission and tried to support the economy by reducing rates, providing moratorium on term loans, and so on.

While reviving growth on a durable basis and mitigating the impact of COVID-19 pandemic on the economy remains key objective of government and RBI. It has another challenge of bringing inflation within the target range of 2% to 6%, which remained well above its upper limit of 6% for a long time.

The situation on COVID front looks lot better than past, even though there are concerns around new variants of virus and increasing cases in some geographies, there is confidence in public and businesses that crisis is probably behind us. Roll out of vaccination program is also adding to the positive sentiment.

Improvement in economic activities and rising inflation are fuelling the bond yields, impacting debt fund returns negatively.

The longer duration instruments are more sensitive to interest rate changes as compared to shorter duration instruments. Debt funds having exposure to medium to longer duration instruments tend to be more volatile in a scenario where there is an upside movement in interest rates.

The rally in debt funds is almost over, one needs to be cautious and have a reasonable yield expectation when investing in debt funds.

Debt funds, having exposure to longer maturity instruments, may be highly volatile going forward, while those focusing on shorter maturity instruments and following an accrual strategy may be still better-placed to tackle the interest rate risk.

Key checkpoints while evaluating debt funds:

While investing in debt funds, the primary objective of most investors is to generate decent returns while keeping their principal intact. But many investors fail to make the right choice on the debt funds category that can meet their objective.

Investors often ignore these basic checkpoints and end up investing in debt funds that are unsuitable and expose them to unnecessary risk.

  1. Match Average Maturity to Portfolio Duration: Debt Mutual Fund are defined on the basis of Maturity Duration; some are differentiated on the basis of Credit Quality and type of instruments they invest in. You should pick debt funds that have a portfolio duration in line with your investment time horizon. You should stay away from longer duration funds if you have a shorter time horizon.
  2. Credit Quality of the Portfolio: In any investment instrument, Risk and Reward are inversely corelated. It’s important to understand the risk associated with the higher return that any instrument is likely to provide, and make an informed choice based on one’s risk appetite. While picking debt funds, many investors give higher preference to past returns. They fail to check the reason behind higher returns the fund generated. If your preference is safety over returns, you should consider funds primarily focusing on Government and Quasi-government securities.
  3. Yield to Maturity: Many investors fail to understand the logic behind higher yield to maturity. Ideally, instruments offering higher yield carry higher credit risk, or have a longer duration and come with higher interest rate risk. So, if you compare debt funds on the basis of YTM, you should not ignore the level of risk it indicates. Debt funds having a portfolio with higher YTM may be carrying risk instruments that are suitable only for investors with a higher risk appetite, i.e., those willing to take higher risk for higher returns.
  4. Fund Management: It is important to understand the fund management style of the fund house; whether they aim to create wealth for investors, or are they in a race to garner more AUM. You shouldn’t ignore the fund management and background before committing your hard-earned money.

What should be the strategy for Debt Fund investors?

These are testing times for debt mutual funds, as the interest rate risk is higher, especially for those having allocation at the medium to longer end of the maturity curve. Moreover, funds having exposure to moderate and low rated instruments may be riding on a double-edge sword of interest rate risk and credit risk.

It is important for you to understand your preferences, time horizon, and risk appetite, and make the right choice of funds. As an investor, If your preference is safety, then stick to liquid funds that focus on Government and Quasi-government securities.

As the interest rates are currently at a multi-year low, the interest rate risk will be higher for funds having their major allocation to medium / longer-maturity instruments, including Gilt funds.

Investors with a longer time horizon may primarily consider a mix of safely managed Dynamic Bond Funds and Banking & PSU Debt Funds. Any allocation to medium or longer duration debt funds should be limited to around 20% of the debt fund’s portfolio, considering the higher volatility (due to interest rate risk) in this segment.

You may also set aside some funds in safe liquid funds (around 20%) and can scale up your investments in Dynamic bond, Banking & PSU Debt Funds, and Gilt Funds through additional purchase when the interest rates show a sharp upside move.

This way you could gradually build a long-term debt fund portfolio as well as minimise the interest rate risk when the interest rates are trending upwards.