Are debt funds getting riskier?

Within the same category, there are schemes involving distinctly different strategies; investors need to be careful

Investors in equity mutual funds are used to being told that these schemes are risky in nature and long-term investment is the best way to mitigate this and earn reasonable returns. In stark contrast, debt fund investors are more or less assured of their returns. And, since these returns, though higher than from fixed deposits, are not spectacular, most feel they aren't putting money in risky instruments.

However, things have been different for some time. Debt fund investors have been forced to worry about their investments as well. If JPMorgan's 'side-pocketing' of its Amtek papers wasn't enough, many companies' paper have been downgraded by rating agencies, creating fear among investors. Side-pocketing is done by hedge funds to separate illiquid assets from other more liquid investments. Once an investment enters a side-pocket account, only the present participants in the hedge fund will be entitled to a share of it.

U K Sinha chairman of the market regulator, the Securities and Exchange Board of India, even warned fund houses that they use their own expertise while investing in debt paper of companies. In a meeting last month, he said the exposure of fund houses to downgraded papers had increased from Rs 4,000 crore in July to Rs 13,000 crore in August. Amid these worries, how should investors look at debt funds is a million-dollar question.

Amit Tripathi, chief investment officer, Reliance Mutual Fund, says investors should look at two things before choosing a fund house. One, the team strength, research and expertise. Two, fund house pedigree, track record and net worth.

"The main reason investors have been putting money in debt funds is because interest rates are on a downward trail. And, interest will be on a downward trajectory for the next two years. So, money will be made by investors putting money in debt funds. But, do investors really understand the kind of scheme they have invested in?" says Hemant Rustagi, chief executive, WiseInvest Investment Advisors.

This question is important because there are a huge variety of debt funds. There is ultra short-term, liquid, gilt short-term, medium and long-term, and income funds. While these are broad categories, there are a number of varieties in these, too. For example, in the income fund category, there are dynamic funds, credit opportunities funds, inflation-indexed funds and so on.

"An investor needs to understand their risk profile and then invest in these funds. Investors tend to do badly when they want to take advantage of a market situation but are completely unaware of how to deal with the risks involved in the situation," says a financial planner.

There are different types of funds in each category. In the current circumstances, investors are seeking money in longer-term income funds because of the falling interest rate regime. However, if we look at two types of funds in the same category, fund managers' behaviour is quite different.

There are dynamic bond funds in the income fund category, which keep changing their papers according to the situation. Fund managers of these schemes have a lot of liberty. They have the flexibility to move into short-term or long-term instruments, depending on the fund manager's outlook on interest rates. If the manager expects rates to fall in the near future, he will start taking exposure to longer-tenure debt paper or position the portfolio on the shorter end of the curve.

The fund manager also has the liberty to move completely into short-term instruments like commercial paper or certificates of deposit. Or can take exposure to longer tenure paper like corporate bonds or gilt securities. The flexibility in managing such a fund can be seen from the variation in average maturity and duration. However, most experts consider these funds safer, as the fund manager does not take too much credit risk but takes an interest rate risk.

In the same category, there are credit opportunities' funds. Here, the fund manager takes a credit risk to improve returns. So, the quality of paper might see some compromise. Unlike gilt funds and income funds, which invest largely in AAA-rated paper, these funds invest across the credit spectrum. Typically, a large chunk of their portfolio is in AA or lower-rated paper. Since they take a higher risk by investing in lower rated paper, they have the potential to give higher returns. And, as a result, if you want to get higher returns but are willing to take the risk as well, these funds might be good for you.

No wonder Tripathi believes investors need to match a scheme's suitability in terms of investment time horizon and investment appetite. Given that in the past year or so, the taxation of debt funds has changed, Rustagi also believes investors need to match their time horizon with the taxation aspect. Investors who have invested in debt funds of more than one year need to stay invested for at least three years to get the indexation benefit. Otherwise, the capital gains will be added to their income and taxed.