- Date : 10/09/2020
- Read: 7 mins
It’s the quality of bond that matters the most when it comes to debt funds, but they are volatile and dependent on interest rates as well.
Franklin India Short Term Income Fund, the most popular of the six debt funds that asset management firm Franklin Templeton shut down on April 23 this year, delivered a compound annual growth rate (CAGR) of 7.81% between 1 November 2016 and 1 November 2019.
In November 2016, the three-year fixed deposit (FD) rate of the State Bank of India (SBI) was 7%, so on paper, returns from the fund seemed only slightly better. The latter, however, scored when tax benefits were considered. Moreover, analysts found Franklin Templeton’s strategy – of taking on higher risk in their debt portfolio – to be transparent. As a result, mutual fund distributors were more successful in selling these funds to India’s risk-averse middle-class investors than FDs.
So when Franklin Templeton said it was closing down the six high-risk debt funds, and attributed the decision to redemption pressures and illiquidity in the bond markets, investors were aghast. Aren’t debt funds supposed to be a safe investment, they wondered. But to answer that, we must first understand what a debt fund is and how it really works. This will also help us decide whether debt funds such as corporate bond funds are altogether risk-free or not.
A bond fund is a mutual fund that primarily invests in bonds and other debt instruments. The exact type of debt the fund invests in will depend on its focus. However, in general, these investments are mainly fixed-interest generating securities such as bonds issued by governments, corporate entities, and municipal bodies. Each of these carries its own unique set of risks.
Investments can also be made in other money market instruments, including convertible bonds where the investors convert the amount invested into equity of the issuer company. Still, debt funds don’t guarantee positive returns despite being fixed-income instruments because of interest rate risks and credit risks.
Credit risk arises as a debt fund’s net asset value (NAV) tends to fall with a rise in the overall interest rates in the economy, which makes long-term debt funds unsuitable in a rising interest rate regime. (It is the opposite when rates are falling though). In credit risk, the fund manager may invest in low-credit rated securities that are more likely to default. This makes debt funds riskier than bank FDs.
Moving specifically to the corporate bond mutual fund, this is a fixed-income security that predominantly invests in bonds issued by private sector companies.
A corporate bond pays interest throughout its term period, and the principal upon maturity. It is known for providing high returns with a relatively low degree of risk, as these funds typically invest in high-rated instruments. At least 80% of their total assets go into the highest-rated corporate bonds.
At the same time, this type of mutual fund sometimes also invests in government securities; this is usually when there is no other suitable opportunity. On an average, exposure to sovereign fixed income is around 5% of allocations.
Not all debt papers that corporate bond funds invest in are bonds; companies also issue debt papers, which include bonds, debentures, commercial papers, and structured obligations. If you are an investor who prefers a fixed but higher income from a safe investment option, corporate bonds are a good choice. This is primarily because they are low-risk when compared to other debt funds as they ensure capital protection.
If your fund manager invests only in highly-rated companies, expect an average return between 8% and 10%. Here too, the risk is minimal. This way, your fund manager can help you progress faster towards your financial goals by opting for corporate bond funds that invest in high-quality debt instruments.
Similarly, if your fund manager opts to invest in a somewhat lower-rated fund that is nevertheless well-managed, it can prove rewarding for you. This happens when companies tend to give slightly higher coupon rates to attract investors. But this strategy can misfire too, as we saw with Franklin Templeton. We shall explore this in detail in a later section.
As stated earlier, long-term debt funds can become a risky proposition when interest rates are volatile. It is to ride out this volatility that corporate bond funds tend to invest with an investment horizon of one year to four years.
There is an added benefit if you remain invested for up to three years, especially if you fall in the highest income tax slab. This is because capital gains from debt funds are taxable, and Section 112 of the Income Tax Act comes into play if your investment is for three years or more. Under this section, a flat long-term capital gains tax of 20% is charged with indexation.
(Short-term capital gain is applicable if units are sold within three years, with the tax rate being as per one’s tax slab; so if you are in the 30% tax bracket, your STCG is 30% plus a cess of 4%).
If planned well, an investment in a debt mutual fund can also prove to be tax-efficient.
As stated earlier, debt funds tend to run an interest rate risk, as any increase in rates is likely to lead to a fall in the bond prices, affecting bond fund returns. Moreover, one can’t rule out the possibility of bond issuers defaulting on their obligations. This default risk is higher for low-rated securities and goes up exponentially with increasing maturities.
There is also the chance that your fund manager may take a wrong call by backing a company with dubious financial or practices. So, if the company you backed (or that your fund manager backed on your behalf) defaults on interest/principal repayment or if it gets downgraded further, it is your investment that will suffer.
The Franklin Templeton fiasco
You will probably wonder who could possibly want to invest in low-quality bonds when one can buy high-quality bonds and not have to risk one’s investments. As mentioned earlier, the attraction for low-quality bonds is their high interest rates, as opposed to the relatively modest rates offered by high-quality bonds.
Fund managers who can play it smart or take the risk for higher returns will go for low-quality bonds. Franklin Templeton (FT) was one, boasting of a high allocation of low-quality bonds in its portfolio. And this worked out pretty well for a while. But the inherent flaw in the strategy was exposed because of Franklin Templeton’s high allocation in Vodafone Idea and Yes Bank bonds.
"This strategy (taking high risks for high returns) started to show cracks over the past 18 months, since ILFS, Vodafone, etc," according to Sanjiv Singhal, founder of financial company, Scipbox. "FT created side pockets in these funds to hold defaulting/suspect debt," Singhal was quoted by CNBC TV18.
In January this year, a Supreme Court decision went against Vodafone Idea and it defaulted. In March, Yes Bank collapsed. To make matters worse, panicky investors started to withdraw their money after the COVID-19 pandemic broke out, leading to redemption pressures in an already illiquid bond market.
Normally, Franklin Templeton would have had new investors on board to help them pay the investors who were withdrawing, but in the changed circumstances there was nobody to take the risk of buying low-quality bonds. For a while, Franklin Templeton borrowed money to make payments, but this was not sustainable and the six funds had to be closed.
To return to the original question (‘Aren’t debt funds supposed to be a safe investment?’) the answer is: yes they are, but they are also volatile. Returns vary with interest rates; they fall if interest rates increase, and rise if interest rates fall. This apart, a long-term debt fund is more volatile as compared to short-term bonds.
The most important aspect of debt funds that one must keep in mind before investing in them relates to the quality of the bond. As borne out by the Franklin Templeton debacle, a low-quality debt fund might offer higher returns but the twin dangers of default and loss of principal are a very real possibility.
For their safety, investors are advised to check bond ratings; for instance, CRISIL’s AAA rating is the highest-rated bond quality. Here's a dummy’s guide to investing in government bonds or G-Secs.
Disclaimer: This article is intended for general information purposes only and should not be construed as tax or investment or legal advice. You should separately obtain independent advice when making decisions in these areas.