Why Debt Mutual funds gave negative returns?

Mutual funds are attracting lot of investors because these are considerably safe investment avenue with higher returns. These have been broadly classified into three categories namely equity, debt and hybrid funds. Debt fund seems like a better alternative to Fixed Deposit primarily due to higher return and tax benefits to retail investors. In this article we will focus on debt funds and their returns.

What are debt funds?

A debt fund is merely a collection of such bonds where fund manager invests/lends to various issuers. Let us look at the advantages of selecting debt funds over fixed deposits and the underlying risk. Debt Mutual funds offer high returns compared to fixed deposits in general. The returns on debt funds vary from 6.5% pre-tax to up to 12% pre-tax compared to FD returns of 6.5% -7%. The return on debt mutual fund is subject to long term capital gains if held beyond 3 years and effective tax rate could come to well below 10%. The fund invests into various instruments thereby offering the diversification of risk of lending to one entity. Often the fund manager spreads it across 20-25 companies, Banks or State Governments or Central Governments.

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How does their prices get affected?

Debt market is dependent on the business borrowings, stage of economy, consumer spending and government policies. A good and rising economy means businesses are producing and selling more and more, consumers are buying and spending more. All of this is fueled by the borrowing and therefore the demand of money goes up which increases the interest rates as demand of credit has gone up. However, when the economy goes down, businesses cut down on productions, consumers spend less and demand for funds/money goes down and supply goes excess which reduces the interest rates. Governments also try to reduce the interest rates in the system and encourage business and consumers to borrow cheap and support expansion or spending. Since interest rates movement are inversely proportional to the bond prices a higher long tenure bond yield means less funds would be deployed in lower tenure bonds and current rates fall. Investors start to expect that interest rate will fall more in future which further leads to an increase in current rates. This works best for existing bonds. This same kind of scenario was expected when Corona crisis hit the economy, but surprisingly debt funds gave negative returns.

Why were debt funds giving negative returns?

The price of Debt Mutual Fund is sum of interest accrual on the underlying bond and the mark to market price of the underlying bond.

As the yield on the long tenure bond increase the bond prices come down and although the accrual component is fixed the mark to market component of the NAV brings down the NAV. The extent of reduction in the NAV due to prices is based on the duration of the portfolio of bonds and higher the duration more is the reduction in bond prices and therefore the mark to market loss.

The financial market experts say similar situation happened recently because money market faced a stalemate in its instruments in the months of July 2020 to September 2020. Experts cited various reasons for this situation:

1.The month of August 2020 sent jitters to debt fund investors as most of the categories were giving negative returns. The low GDP data and GST collections amidst high inflation put upward pressure on yields.

Category average returns in August (%)

2. Foreign portfolio investors got jittery and were selling heavily in both equity and debt markets which again exacerbated the situation

3. Banks were busy in settling down their NPAs and consolidation process. Banks kept more cash with themselves when uncertainty looms over the economy. It means less money supply in the economy for investment.

4. There were lot of redemptions in mutual funds. The selling pressure for bonds and other money market instruments in secondary markets were driving down the prices.

Passive funds are not that popular in India but gradually they are gaining popularity now as more and more people are getting aware about it.

All these situations created a negative scenario for debt funds because the instruments in the portfolio are marked for daily valuation of net asset values (NAV).

What did RBI do to ease the situation of debt markets?

Reserve Bank of India extended a helping hand to debt market investors by easing the problem. RBI purchased government securities from the market which injected the money supply into the economy that led to boost the demand. It also infused money into the banks through Long term repo operations so that banks’ financial statements were not deteriorated and encouraged them to lend for investment purposes. It also tried to strengthen the rupee by supplying US dollars to the foreign exchange market.

On 27 March 2020, RBI trimmed the repo rate and reverse repo rates. Lower interest rates mean costs of investment comes down which encourage people to borrow/purchase as loans are available at lower rates. RBI’s action to introduce LTRO (long term repo operations) was praiseworthy. LTRO encouraged banks to invest money in bonds and commercial papers which caused a boost in the demand of these instruments. These instruments started to attract investors causing higher demand. It will cause the yield to come down as prices would move up. This has directly impacted the mutual funds as NAVs became better. That is how RBI made debt market investors better off.

What apprehensions do people still hold?

Whenever interest rates come down, investors start to purchase bonds as they see it as a good time to invest. Investors are also apprehensive about credit defaults since defaults are higher when economy is not performing well. Experts say that investing in banking and PSU funds and corporate bond funds are relatively safe since their credit quality is better. Investors should keep patience and stay invested but if yields continue upward trend then investors should shift their funds within debt category. Experts are of the opinion that interest rates may go up in future therefore long duration debt funds should be avoided.

Conclusion

Allocate your assets in the portfolio so that your long-term financial goals can be fulfilled even after facing some jitters. Investors should focus on strengthening the core portfolio. Investors need to be conscious of their risk-taking capacity and the time horizon for which they want to invest in debt. Investors who want to park their funds for very short duration then there are evergreen categories like overnight funds, liquid funds because these are less volatile. It is to be noted that high returns are obtained by taking high risks therefore investors should keep a close watch on credit risks in debt fund portfolio.