Debt Funds – Has The Time Come To Say Goodbye?

Now Is The Time To Say Goodbye To Debt Funds

Debt funds are not safe, and unless you time the entry and exit, they seldom reward you.

Asset Allocation is a buzzword these days. Haven’t you met a financial planner recommending you to follow a right asset mix? As they say, “don’t put all your eggs in one basket.” Well, no disputes there.

Investing in various asset classes that don’t move in tandem with one another helps you spread the risk involved in investing. However, that being said, you should make sure you don’t put eggs in the wrong basket.

Yes, you read it right. You should be confident that you are trusting the right basket.

Broadly, there are four asset classes—equity, fixed income, gold and real estate. And within each asset class, you would get many alternatives allowing you to diversify further. For example, while investing in equity, either you may invest directly in shares of listed companies, or prefer the option of mutual funds. Moreover, you can invest across sectors, and within each sector, you can diversify across companies of different sizes.

Alternative to debt funds

When it comes to investing in fixed income assets, there are some misconceptions. Many investors fail to understand the difference between fixed deposits and debt funds. Consequentially, they end up investing in debt funds without even perceiving the risk they are exposed to.

Over last 2 years, many debt funds have generated double-digit returns. That phase seems to be a history now. Advisors often lure investors by showing them historical returns. But like in the case of any other asset class, historical returns generated by debt funds don’t tell you anything about their performance potential.

Fact check…

Debt funds are not safe, and unless you time the entry and exit, they seldom reward you.

Broadly, debt funds come in two genres—Duration funds and accrual funds.

Duration funds, to a large part, try to make money by betting on the direction of interest rates. If interest rates keep falling, bond prices rise, as both share the inverse correlation. Therefore, a fund manager of a duration fund tries to make gains when bond prices move up.

On the other hand, accrual funds don’t try to earn through capital gains. They rather depend more on the credit quality of bonds. Their primary source of income is interest paid on the bonds they hold. Funds following this strategy endeavor to hold bonds until maturity.

So far debt funds that may have generated double-digit returns over last 2 years have managed to do so, primarily because interest rates in the economy were going down.

Can they repeat their performance for another two years?

Since January 2015, the RBI monetary policy turned accommodative; which means whenever the macroeconomic indicators permitted a policy rate cut, RBI reduced rates.

On February 08, 2017, RBI published the sixth bi-monthly monetary policy review of FY 2016-17. There were some surprisingly shocking announcements in the policy statement. Here onwards, the policy will remain neutral, and RBI would be ultra-careful even if macroeconomic indicators turn supportive for the short-term.

Banks have started considering possibilities of lowering interest rates even on savings bank accounts, making the things worse. And banks are unlikely to raise interest rates on deposits soon as there is no dearth of money with banks, thanks to demonetization.

As consequence of these developments, the Indian bonds nosedived in a jiffy on the day of the policy announcement. In effect, NAVs of many debt funds declined in the range of 0.23% to 1.91%.

Can you imagine the Net Asset Value (NAV) of your debt fund falling like that of an equity oriented mutual fund?
Be ready for more surprises…

Policy rates have no further room to fall. The neutral stance adopted by RBI has made predicting policy movement exceedingly difficult. This has made the journey of duration funds more difficult. Going forward, debt funds working on accruals may also generate lackluster returns simply because interest rates won’t be attractive enough anytime soon.

Bond markets are difficult to understand and thus even tougher to time rightly. Those who entered long-term debt funds only a few weeks before the RBI announced sixth bi-monthly monetary policy review on February 08, 2017,  now run a risk of generating poor returns on their investments over next 2 years.

This is why you shouldn’t blindly trust the past performance of any asset class hoping it to continue in future as well.

Under such a scenario, investing in P2P lending projects is one of the most attractive options.

Why is P2P Lending a better alternative to debt funds?

  1. Unlike debt funds, returns on P2P Lending projects are predictable and dependable.
  2. In the past, it’s been experienced that, debt funds don’t carry out risk assessment meticulously and do an ordinary job in protecting the investors’ interest. Haven’t you read about some debt oriented mutual funds making massive losses because of bad asset quality?
  3. To select a debt fund, you either have to depend on an advisor, or you have to do research on your own. Because looking at them, you can never guess which fund holds a sound portfolio and is likely to generate decent returns in future.
  4. However, in the case of P2P Loans, decision making is straightforward for you. At i2iFunding, our credit assessment team leaves no stone unturned to understand the risk and price it appropriately. You can trust the risk grade assigned by i2iFunding and the interest set for each risk category.
  5. Interest rate movement doesn’t easily affect interest rates on P2P loans. Wait a minute, this is not because P2P platforms are not transparent in setting interest rates, but it’s more a function of loan underwriting. Banks and other financial institutions refuse to lend to aspirant borrowers with no or limited credit history. Unlike them, Peer to Peer Lending Platforms such as i2iFunding put an extra effort to understand the risk involved in each loan project and set the interest rate accordingly. So far, i2iFunding has managed to maintain the default rate at near ZERO.

Take the risk of being in debt funds even now, only if you are okay with muted returns.

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One comment

  • Ashnit Jaiswal

    Nicely put.
    There are still risk involved in p2p lending platforms/ company such as
    1. As p2p market size become larger and known default rate will rise. The negative effect of pressure of achieving high revenue target for growth of funding will manifest as rise in default rates. There is no scientific data that show the correlation between risk profile assesment process of borrower/ project / company and defaut rate/return. Which is similar to track record of a fund manager in case of mutual fund. Beside that how returns varies along with various macro economic data.
    2. This is a suggestion. The risk profile assement process used by your company or any p2p platform should be ranked or certified by any credit rating agencies like crisil , etc. This will induse trust in the people. This ranking will not only disrupt debt mf but also various sector based equity mf and liquid mf.
    Thus lack of trust exist.
    3. One lacking point liquidity is a issue even if emi start crediting into lenders account. Lender cannot withdraw money in case of contingency or when they feel they need money some where else at that point in time.

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