Should we continue to invest in debt funds?

m2Should we continue to invest in debt funds? That’s the question being asked by many investors right now. While professional investors and corporate CFOs who use debt funds to park cash may have an understanding of the upheavals that are taking place, small investors who have started using debt funds are a bewildered lot. Investors expect debt funds to give stable returns, even over short periods of time.

Investors’ understanding is that debt funds can exhibit volatility from day to day but expect this to be smoothed out over the course of a few days.

They expect this to be so for the longer maturity debt funds. However, for shorter maturity debt funds, they have an expectation that returns will be more or less in a straight line. For liquid funds, which are subject to special mandatory constraints that should limit their volatility, investors expect that there should never be a negative day.

The debt fund trend turned after May 22; and by June 12, some types of debt funds had recorded far worse returns than the worst their investors had any expectation of. During that time, long- and medium-term government security funds (gilt funds) recorded a loss of 1.11% and the general category of income funds recorded a loss of 0.84%.

However, last week has brought another series of shocks that left no category untouched. Between Monday and Wednesday, gilt funds lost 2.14% and general income funds 1.67%. Even liquid funds, which were thought to be immune from even a day of losses, lost an average of 0.18%.

One May 16, some liquid funds lost as much as 0.38%. Of course, the primary cause of these losses was RBI’s action of tightening the supply and rate of its overnight funding facility for banks. This fostered a widespread collapse in the value of bonds and resulted in losses for all types of funds.

Gilts and longer maturity funds can be expected to smooth out the worst volatility only over a period of several months to a year. Even so, they are vulnerable to shifts in interest rates. Shorter-term funds can have a horizon of a few weeks. However, liquid funds can be expected to straightline in at most a week even in the worst case. This is actually true even in the current upheaval. The reforms that Sebi had instituted in liquid funds’ investment and valuation norms have functioned well.

The problem has been with investors who had imagined liquid funds to be immune to any losses, even on a single day.

The trickiest problem is that of dynamic funds, where the fund manager is supposed to decide whether the fund is supposed to change the composition of the fund based on interest rate expectations.

Unfortunately, the promised has not been realised and from May 24 till now, dynamic funds have performed terribly – losing an average of 3%. Investors need to seriously reevaluate the way dynamic funds have failed to deliver.

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