Debt MFs will continue to prosper

Debt mutual funds have got significant bad press in the past few months. With several corporate groups defaulting, and constant downgrading of many companies’ debt papers, it would seem the end of the world for debt mutual funds.

The popularity of debt funds is evident from data from the Association of Mutual Funds in India (AMFI). As on March 31, 2019, the total exposure to debt papers by debt-oriented mutual funds (non-gilt and non-liquid) is around Rs 7.21 trillion. Retail investors hold a nominal 10 per cent, but in terms of folios the number is around 8.6 million, which is significant.  Even if we assume 2 folios per individual, the number would be 4.3 million.

The reason: These funds are convenient, in terms of flexibility to invest large sums and withdraw amounts in tranches with full accrued interest till date (though some funds have exit loads during the first 12-18 months). Moreover, people with incomes above Rs 10 lakh can defer the tax till they withdraw. And if withdrawal is made after three years, it enjoys a concessional tax treatment of 20 per cent on gains after indexation.

Their only disadvantage is that mutual funds cannot guarantee returns and carry both interest and credit risk. Currently, credit risk the main worry for investors.

The simplest way of dealing with it is by separating the tainted security from the main scheme, and all investors existing on that date become entitled to a proportionate share of any realisations as and when received from that security. The balance scheme continues as it is, which the investor can continue to hold or sell. Even if the investor sells his units in the balance scheme, he continues to have a right to collect his pro-rata share in the separated security as and when there is a realisation. This is called side-pocketing in market jargon.

This brings us to the future of debt mutual funds. If an investor is holding a debt fund for three years, and the return is around 7 per cent, investors in the top income-tax bracket would earn a higher return than a fixed deposit giving similar returns. And despite good exposure to these companies, fixed maturity plans that have gone in for side pocketing have paid at least the principal amount on maturity. Time will tell whether there will be some realisation from the side-pocketed security.

Then, there are other options for the high networth taxpayers who do not want credit or interest rate risk – arbitrage funds. But they are not suitable for a concise period such as a few days or a month or so. For that, overnight funds or banking & PSU debt funds are more suitable. 

As far as retail investors are concerned, debt mutual funds continue to provide several advantages that bank fixed deposits cannot match due to their inherent tax advantages and flexibility. Like Mark twain justifiably claimed “the reports of my death are greatly exaggerated”.

The writer is a Sebi-registered investment advisor