Debt funds are not as "safe" as they sound.

20th Apr 2013 ARCHIVES | EQUITYMASTER HOMEPAGE

A client who wishes to minimise risk says: "I want to be really safe please make sure your
!ersonal"# financial planner puts all my money in a debt fund."
And that ri$ht there is a dan$erous misconception.
Debt funds are not "really safe". %hey ha&e a lot of inherent risks in them which you should be
aware of before you decide to in&est in them ' e&en if they ha&e been recommended by your
financial ad&isor.
And for the "e(tra risk" that you ha&e taken in debt funds compared to li)uid funds *or bank
"Ds+ you should be compensated with a hi$her return.
Safety is not assured.
A debt fund in&ests in securities which typically mature more than ,0 days. -ost debt funds
may ha&e in&estments where the a&era$e maturity is anywhere from 3 years to . years. A li)uid
fund by contrast in&ests in securities that mature in less than ,0 days.
%he lon$er one is in&ested in somethin$ the hi$her the chance that somethin$ can $o wron$:
the risk increases.
"or e(ample if you lent money to your nei$hbour for one day the "risk" of him not payin$ is
limited to that one day. /ou will make your decision on whether to lend *or not to lend+ lookin$ at
&arious factors that could $o wron$ *or ri$ht+ in that one day period. "Is your nei$hbour likely to
disappear o&erni$ht0" may be your first )uestion1
2ut what if the nei$hbour asks you for a loan for 10 years because he wishes to build a factory
to manufacture cars0 #ow your entire assessment of the loan should ha&e chan$ed. In addition
to worryin$ about whether your nei$hbour will disappear for 3342 ni$hts *10 years ( 334 days
plus some lap year days1+ you need to start askin$ him a whole bunch of )uestions *why cars
what is the demand competition ser&ice centres where will he $et the money from when will
he start production where will he $et his raw materials from etc. etc.+. And you will also worry
about the rate of interest you should char$e him. If you char$e him say 105 you will feel
foolish if the rates of interest sur$e to 205 ne(t month. If you had not locked in your money at
105 you could ha&e been a lender at 205. 6owe&er if the rates of interest decline to 45 you
will feel $ood that you locked in your loan at 105.
7eepin$ this basic principle in mind: the lon$er you are locked in the hi$her your "risk" here is
a $raph of two funds from 6D"8 -utual "und: one is a li)uid fund and the other is a fi(ed
income fund.
Grap !" H#$C $i%ed In&o'e $und does (etter tan te H#$C )i*uid $und+ fro' O&to(er
,--- ti.. Mar& /!+ ,-!/0
%he 6D"8 9i)uid "und has a portfolio with an a&era$e maturity of 43 days as per the fact sheet
of -arch 31 2013.
%he 6D"8 "i(ed Income "und has a portfolio with an a&era$e maturity of ,.:4 years as per the
fact sheet of -arch 31 2013.
#ote how the 6D"8 "i(ed Income "und ' with a relati&ely hi$her risk than the 6D"8 9i)uid
"und because it is locked in securities that mature after , years ' has performed better from
;ctober 2000 when both the "unds were in e(istence.
2ut note the <a$$ed lines of the 6D"8 "i(ed Income "und. %hose <a$$ed lines are a result of
the daily chan$es in interest rates which impact the &alue of the underlyin$ holdin$s of the
6D"8 "i(ed Income "und. And this is in contrast to the relati&ely smooth line of the 6D"8
9i)uid "und.
In&estin$ in 6D"8 "i(ed Income "und is like lendin$ money to your nei$hbour for 10 years '
se&eral unknowns impact the 2 key factors: "will I $et my money back0" and "at what interest
rate should I ha&e lent the money0" And you may worry about this e&ery day ' with &aryin$
de$rees. =o that <a$$ed line represents this continuous worry o&er lon$ periods of time.
In&estin$ in 6D"8 9i)uid "und is like lendin$ money to your nei$hbour for 43 days *that is the
a&era$e maturity of the securities it owns+ $ettin$ it back from him and decidin$ to lend it to
him a$ain for 43 days a$ain ' sort of rollin$ o&er the loan within a short period of time if you felt
like it. And if you feel uncomfortable ' because somethin$ may ha&e chan$ed in your
assessment of his ability to pay or e&en in the interest rate you wish to char$e him ' you can
decide not to roll o&er the loan. %he smooth line represents the "43'day" worry.
;f course like in any in&estment when you in&est also determines whether you made money '
or $ot compensated ' for the hi$her risk.
As you can see an in&estment in the 6D"8 9i)uid "und would ha&e $i&en you better sleep
*fewer <a$$ed lines+ and a better return than an in&estment in 6D"8 "i(ed Income "und since
>anuary 1 200:.
Grap ," H#$C )i*uid $und does (etter tan H#$C $i%ed In&o'e $und+ sin&e 1anuary !+
,--20
?eco$nise that a li)uid fund and a debt fund both own securities which $i&e a fi(ed rate of
return. 2ut the funds are different. And you need to be aware of that and see whether it matches
your potential needs.
Ta(.e !" 3y te $unds are different
)i*uid $und #e(t $unds
@hat does the "und typically
own0
;bli$ations of a borrower to repay a
certain amount called the principal at
a fi(ed time
;bli$ations of a borrower to repay a certain
amount called the principal at a fi(ed time
Interest earned on in&estments0 %ypically .5 to A5 %ypically A5 to 105
%enure: when will the money be
returned to the "und0
6as to be returned within ,0 days ?an$es between 3 years and A years
8an these holdin$s be sold by
"und to someone else is there
a secondary market0
/es these are traded acti&ely but
most "unds will hold these till they
"mature" and the borrower repays the
loan
/es these are traded acti&ely and most
"unds will sell them in the secondary market
@hat happens if interest rates
sur$e sharply0
8an rein&est )uickly in instruments
that $i&e hi$h interest rates
=tuck ' will take a lon$er and lar$er hit on the
portfolio &alue the #AB
@hat if interest rates fall
sharply0
@ill be forced to rein&est the portfolio
at lower interest rates then the future
returns will decline ' but no lon$ term
loss on the portfolio &alue the #AB
@ill see a lar$e sur$e in the &alue of its
portfolio of e(istin$ securities sur$e in #AB
=hould this be in your portfolio0
/es as an alternati&e to "i(ed
Deposits particularly if you need the
money in a shorter unknown period of
time
;nly a small proportion of your "fi(ed
income" portfolio should be in thisC this
actually is for more sophisticated in&estors
who wish to "make a call" on the direction of
interest rates
%ypical commissions paid by
mutual fund houses to
distributors and financial
ad&isors who "sell" this
product0
0.045 to 0.105 0.305 to 1.05
=ource: !ersonal"#
In&estors lookin$ to in&est in instruments which ha&e a fi(ed rate of return and want to ensure
that their capital &alue is secure should consider:
1. %he &arious ta('incenti&e sa&in$ schemes like !ostal =a&in$s
2. %he "i(ed Deposits at different banks
3. %he 9i)uid "unds.
%he rates of return in these abo&e instruments may not compensate you for the increase in
prices for inflation. 2ut your capital is safe.
"or those wishin$ to earn hi$her returns to beat inflation and take some risk on their capital
there is the option of in&estin$ in the &arious debt funds. %hey may be called "-! monthly
Income products or debt funds ' but reco$nise that their underlyin$ portfolios are sub<ect to
more risks than the li)uid funds. And there could be sharp chan$es in the #ABs on the date you
redeem and ask for your money back ' and these may affect your rate of return.
A$ain there is nothin$ wron$ about fi(ed income funds ' Draph 1 shows how the 6D"8 "i(ed
Income "und has performed better than the 6D"8 9i)uid "und since ;ctober 2000. %he points
to note are:
1. the risk *the <a$$ed line+ and whether you ha&e been compensated for the underlyin$
risk
2. you may end up redeemin$ at the wron$ time 'when the #AB has declined ' resultin$
in a potential loss or in a much lower return than in the "more safe" li)uid fund *as
Draph 2 indicates+.
At the end of the day you should be in&ested in &arious asset classes *fi(ed income e)uities
and $old+ in different instruments within each asset class *for e(ample in "fi(ed income" in&est
in "Ds li)uid funds debt fundsC in "e)uities" in&est in a way that $i&es you e(posure to lar$e
cap mid cap and small cap stocks+ in proportions that suit your ability to take risks.
A well'di&ersified and well'thou$ht out in&estment plan will help you ride out the bumps of
in&estin$. At the end of e&ery 6onest %ruth there is a table for you to see how one can decide
allocations across &arious asset classes dependin$ on future estimated needs. 2ut your $oals
and risk appetite will be different from others so you should tweak this to suit your needs ' or
consult a financial ad&isor to help you with the e(ercise.