What Not To Look For When Investing In Debt Funds

We usually discuss what to look for while investing in an asset class (such as equity, debt, gold, etc.) or through an investment vehicle (for example, mutual funds or portfolio management services). However, what not to look for is also important, for your clarity. Here are some of the aspects that should not play a role in your investment decision.

Returns, Particularly Immediate Past Returns

You would be wondering, returns is what we invest for; so why ignore that. What needs to be appreciated here is that an investment in a vehicle, for example, a mutual fund, is not an investment ‘in’ the vehicle itself but ‘through’ the vehicle. Ultimately, it is the underlying market, with all the volatility and uncertainty, where your investments will reach. A market may be relatively more or less volatile. For instance, equity is more volatile than debt. The fund manager’s skills may make a difference, but only so much. Then what should you look at? Performance data over a long period; a period that is long enough to cover multiple market cycles. When you look at performance of a fund or a category of funds over a relatively short period of time, which is in a market cycle such as a bull phase or a bear phase, the data is distorted. 

Here’s an example. When yield levels of government securities (G-secs) are rallying (interest rate and bond prices move inversely), G-sec funds show attractive returns as prices of the securities are moving up and add that much to the returns. Such returns look irresistible as G-secs carry no credit risk and at that point of time, it seems that nothing can go wrong on market risk. In contrast, when interest rates are moving up (i.e., bond prices coming down), investors would not be enthused to invest in G-sec funds. Therefore, the way to look at returns is to see long-period returns, say, 10 years, because that will ensure that both bull and bear phases are covered, which smoothens out the end result.  

Basing Decisions On Expected Returns

This point sounds similar to the previous one, but it is not. When the expected returns from a particular investment avenue looks attractive, you tend to ignore the risks. There was a time when the portfolio yield-to-maturity (YTM, the accrual level of all the bonds in the portfolio) of credit risk funds was better than what it is these days. Investors would look at that number (say, 8 per cent), derive the feel-good factor and invest. During the default cycle, from IL&FS in September 2018 to Yes Bank AT1 perpetual bonds in March 2020, investors were exiting as something called ‘risk’ had hit straight. At present, the default cycle seems to have stabilised, but the category of credit risk funds has dwindled as the portfolio YTM does not look attractive.

To give an analogy, when we are booking an app-cab for local transport, we look at not only the fare (cost is conceptually similar to returns in investments) but also the quality and comfort of the vehicle, the time within which the cab can arrive at the pick-up point, the time expected for the journey, your past experience with the operator, etc. However, while investing much higher amounts of money than we do for local transport, we tend to ignore the other aspects and focus only on the expected returns.

Taking Higher Risks On Low Return Expectations

When the returns expectation from debt investments seems low, people tend to prefer other investment avenues like equity. What we need to understand here is that every investment has its own characteristics of risk, returns, required time horizon, etc. and you have to choose as per your investment objectives, in a ratio that suits you. To draw from the previous analogy, you may not choose the cheapest app-cab for your local travel but one that balances cost and comfort. Similarly, the allocation to equity, debt or any other investment like gold or real estate should be based on matching the profile of the investment avenue with your profile.

As an example, let us say that the portfolio YTM of the debt fund(s) you intend to invest in, which are the fund(s) that suit your requirements, are at a particular level and the expected inflation over the next few months is higher. Debt fund portfolio YTM is not a guarantee on returns, but is taken as a ballpark indication of returns expectation, particularly if the portfolio maturity of the fund is not too long. If you take a view that debt may not beat inflation in the immediate term and build a 100 per cent equity-oriented portfolio, you have to take note of the risk profile as well. If you had the risk appetite for a 100 per cent equity-oriented portfolio, it should have anyways been an equity-oriented portfolio to begin with, without waiting for the debt fund YTMs to fall and not beat inflation.

Remembering Debt When Equity Is Correcting

Many a people remember debt investments only when the equity market is in a bear phase, which is also wrong. If you believe in equities and the India growth story when the equity market is correcting, it is not the time to sell, but to buy more at dips. Since investors do not like volatility, in phases of market correction, there is a tendency to shift to lower-volatility assets (debt) from more volatile ones (equity). However, equity gives you returns over the long run, subject to interim volatility. You have to decide how much volatility you can digest, execute your investments accordingly, and grin through the challenging times, rather than jumping to another vehicle in the middle of the road.

Conclusion

There is a rationale behind every decision, or at least there should be. Be clear about what yours is for your investment portfolio. Once you have convinced yourself, do not vacillate mid-way, unless there is a significant fundamental change in the investment itself. Some change in the parameters like equity market price levels or debt fund portfolio YTM will happen every now and then as expected; these should not make you jump from one investment vehicle to another.

The writer is a Corporate Trainer and Author