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Don’t Shy Away From The Debt Funds, Understand The Risk

Author: D P Singh/Wednesday, July 22, 2020/Categories: Exclusive

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Don’t Shy Away From The Debt Funds, Understand The Risk

There is a saying that ‘Challenging times teach us important lessons!’ All the unexpected events faced in the past by humankind – be it the scale of a global pandemic or environmental issues or even one-off market events– have taught us a lesson and paved the way for evolution helping us emerge stronger and wiser. It is important to stay calm through these events and learn from the experience.

We are currently going through unprecedented times with the outbreak of Covid-19 pandemic. Every citizen across the globe is exposed to its negative implications and so are the businesses. With lack of clarity on the extent of impact this outbreak will have on the global and domestic economy, market functioning has also been disrupted. While dealing with the pandemic crisis, the mutual fund industry was faced with another challenge recently with the closure of six of debt schemes, which resulted in widespread panic among the investor community.

Often investors tend to compare debt mutual funds with other traditional investment avenues. The need of the hour is better understanding of the functioning of these products and how they differ from other traditional investment avenues. Let us understand this from the current market perspective. The reason of closure of six of the debt schemes in the industry was lack of liquidity (the capacity to convert the assets to cash easily) at scheme level to meet investor redemptions. Investors need to understand that liquidity in case of mutual fund is different as compared to say bank deposits.

The money deposited by an individual in banks is classified either as time or demand liability. The difference is time liability are due for payment at a fixed time, whereas demand liabilities need to be repaid as and when requested by individual depositors. In order to keep the liquidity buffer to meet these requests bank can’t lend all of the money deposited with them. As per regulations, banks are mandated to set aside a percentage of the Net Demand and Time Liabilities (NDTL) defined by Cash Reserve Ratio (CRR is currently 3% of NDTL) and Statutory Liquidity Ratio (SLR is currently at 18% of NDTL) to maintain liquidity to meet individual requests. This helps in creating a robust liquidity system for banks.

When it comes to money invested in mutual funds, the functioning is however different. Mutual funds have no such mandate to set aside a sum of money they receive to meet liquidity requirements. Mutual fund schemes’ NAV (Net Asset Value) reflects the daily change in the market value of the securities the schemes invest in. These schemes manage liquidity needs by keeping a certain portion of the portfolio in cash. During times when the market sees heightened volatility, cash levels maintained by fund managers also get tested as investors start redeeming in panic. This is when the fund managers turn to second level of liquidity comes in picture, the credit quality of the portfolio.

Debt securities are assigned different credit rating based on the financial stability and capacity to repay the debt. Government securities (G-Secs) and AAA papers are relatively safer and carry less risk as compared to companies with a lower credit rating. At the fund level, liquidity is defined by the percentage of investments made in highly liquid assets such as cash equivalents, G-Secs and certain AAA papers. Because of the higher quality of these papers they can be easily transacted when needed. Thus, prior to investments, credit quality of a portfolio is a key aspect that needs to be evaluated to ascertain the overall portfolio risk.

Debt funds are classified based on their duration and it is advised that investors should look at investing in short, medium, or long-term funds based on their goals for e.g. for parking money for emergency situations investors can look at low duration or ultra-short duration funds and for longer term goals investors can look at medium duration or corporate bonds funds. However, it is very important to also look at the credit quality of the portfolio. A higher credit quality involves less risk as compared to funds investing in lower rated papers.

It is important for investors to consider all the risk factors before making any investment. While traditional avenues come with a pre-determined interest rate, it is pertinent to note that they are revised based on the prevailing interest rate scenario. On the other hand, while the returns of debt mutual fund schemes vary depending on the movement in underlying securities, different set of funds offer the potential to benefit from varied market scenarios. The return on each investment instrument is linked to the level of risk taken.

In very simple terms, starting a business involves risk, but that doesn’t stop an entrepreneur from following his/her dreams, but encourages him/her to take calculated risks based on the amount of risk they can absorb. Similarly, based on individual requirements there are an array of schemes with varied risk return profile within the debt category which mutual funds offer. The choice of scheme should be a function of one’s risk appetite, expected returns and investment horizon.

As the adage goes ‘’the difference between stumbling blocks and stepping stones depends on how one uses it’ same is true with debt mutual funds also. The key lies to use the stumbling blocks (uncertain market times) as stepping stones to look at systematic allocation in debt funds.

The writer is ED & CMO (domestic business), SBI Mutual Fund


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