Don't fall for agent's pitch on debt funds, go for simpler products instead

Even if a fund is hit due to a default, investors still stand a chance to make better returns than in a bank fixed deposit over the long term

Some distributors have a new pitch for selling debt funds to their clients. According to them, even if a fund is hit due to a default, investors still stand a chance to make better returns than in a bank fixed deposit (FD) over the long term. The pitch may hold true in some specific cases, and calculations a distributor shows may look convincing, but a lot depends on the percentage of the portfolio that is hit by the default.

The pitch goes as follows: Even if 2.5-5 per cent of the portfolio gets hit due to default in a fund giving 7.5-8 per cent return, the investor in the highest tax bracket still stands to make 5.2 per cent or more post-tax return. In an FD fetching 7 per cent, the post-tax return is around 4.9 per cent.

Take the case of an individual who has put in Rs 1 lakh in a debt fund for three years. At 7.5 per cent annualised return, he ends up with Rs 1,24,230 before tax on completing three years. During the course of the investment, assume that the fund is hit by default and 5 per cent of the portfolio is written off. The investor will end up with Rs 1,18,018. After adjusting for indexation benefit, those in the 30 per cent tax bracket will end up with a post-tax amount of Rs 1,16,499. If the investor had put the same amount in an FD, he would have made Rs 1,15,483. If the pre-tax return is over 7.5 per cent, then the post-tax return will be higher.

In a similar scenario, if 6 per cent of the portfolio or more is written off, the post-tax return goes below the return from the FD. “The pitch would work for funds that have a well-diversified portfolio, and not for all credit risk schemes. Exposure to a single entity has to be restricted at 2.5 per cent, and group level exposure has to be capped at 10 per cent for this to hold true. In such a case, the probability of two entities defaulting within a span of three years is low,” says Malhar Majumder, partner and consultant at Positive Vibes Consulting & Advisory. 

According to Majumder, in case of a default, the entire portfolio is not written off. As the loan is backed by collateral, the fund would make a certain amount of recovery too. The corporate houses that defaulted recently were not wilful defaulters. They have been attempting to raise money through stake sale or by other means to pay back the lenders. However, it’s also a fact that in the recent cases of defaults, there were funds that had even up to 25 per cent exposure to the defaulting company and its group entities. An individual investor may not be in a position to know what the outcome will be. "In debt funds, it's always best to seek the help of an investment advisor," says Majumder.

Some investment advisors say that these numbers may hold good only on paper. “Majority of the money in debt funds belongs to corporates. When such a default happens, they are the first ones to exit. In such a case, the scheme ends up selling papers that are the most liquid. The remaining investors have to bear the brunt of the default,” says Deepesh Raghaw, a SEBI-registered investment advisor and founder of PersonalFinancePlan.in. He adds that if a fund sells liquid papers, the proportion of papers belonging to the defaulting company rises withn the overall portfolio.