Debt Mutual Funds, covering all that you don’t know – 10X10Y

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I recently heard a podcast featuring Deepak Shenoy, the brilliant founder of Capital Mind. The one hour podcast covered almost everything about Debt Mutual funds that one needs to know about, as an outsider.

To get started, most of us majorly deal with equity, but yes there exists debt mutual funds and it isn’t all that small. It stands at a staggering 13 Lakh crores which is roughly about 50% of all mutual funds. But it’s a miniscule figure when compared to the Fixed Deposit market which stands at 73 lakh crores, in a country with a money supply of 150 lakh crores.

But why invest in debt funds, when we have FD and Equity Mutual funds? Here, are the advantages :-

  1. When you make a fixed deposit FD, you know the fixed interest rate you are going to get. But in the meanwhile, if you need to withdraw some money out of the deposit, you’re heavily penalized.
  2. You at times need extremely short period investment options to park your money into, like 7/10/15 days which the FDs don’t offer, something especially needed by corporates.
  3. Your money compounds on a regular basis whereas in FD you’re getting an X%. The debt funds lend out the money to multiple institutions, and later re-lend the interest earned. And we’ve heard this before, “Compounding is the eighth wonder of the world”.
  4. Debt funds are relatively cheaper to buy for institutions, as 90-95% directly invest with fund houses saving them 1-1.5% of commission (technically, 15-25% earning) when compared to equity mutual funds.
  5. If you invest for 3 years (to qualify it as a long-term investment as per tax laws), even while you’re earning the same rate as FDs, you can pay close to 80% less taxes.

Debt funds are usually classified based on their liquidity/duration,

The key is to match your investment horizon with your investment duration.

The other types of classifications are also on the basis of :-

  1. Corporate Ratings – Debt MFs are also classified on the basis of the rating of the Corporate bonds they will specifically invest in – AAA, AA, etc. AAA is the highest rating for a company followed by AA, A, BBB, BB, B, C, D. But note that, DHFL and IL&FS were also once rated AAA, and they defaulted, thus these ratings don’t really imply much.
  2. There are also few other short-term instruments like commercial paper and Certificates of Deposits (CDS) where banks and corporates issue what are money market instruments, which are issued for less than 1 year in duration.
  3. Government Bonds – Then there are Government bonds can be bought for less than 1 year in duration – typically these are called T-Bills. Government securities (G-Secs) are typically for 1 – 50 years in duration. There is also non-convertible debentures (NCD) – bonds of more than 1 year in duration.

    There are also funds that invest only in government bonds and are called GILT funds. They will buy only government issued paper. What’s the difference? The government won’t default, it can print money and give it back to you whenever it wants if it were really in trouble but not a corporate. (If you’re keen on learning more about the money printing economics, you can click here)

  4. Dividend vs Growth – The debt funds also come in with the option of Dividend (you’re paid tiny dividends) vs Growth (dividends are not paid, but they’re reinvested), regular (you pay commission) vs direct (you buy directly from the house with no intermediaries eating a commission) just like equity mutual funds. The funds have different products with a Permutation and combination of these options, and you stand to benefit the most with the Regular Growth products.
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There is also a very interesting bond called an Additional Tier One (AT1) bonds. The concept is simple – please give me your money and I will pay you 10% interest per year (WHAT??? YES YES 10%). But there’s a catch of course, *drum roll please* I’ll only pay your principal investment amount back if things are good after 10 years or if I really like you. Something similar happened in the Yes bank fiasco. These bonds were sold to masses without informing them of the risks. Many were retired people who thought it was an FD. When people asked for their money back, they just said sorry. Investors then asked, how can you even do this? They answered, please read the contract.

Debt Funds Disadvantages & how it is impacted in today’s situation :-

  1. These funds have a big accountability issue. When you buy a FD from a bank, the bank is accountable to pay you back. No PNB Fixed depositor lost their money when Nirav Modi defrauded PNB. However, if you had bought a Debt fund that invested a portion of your investment with Niravji you would have suffered losses, the fund house doesn’t have the obligation to cover your losses. Thus, debt funds have a high-risk high return proposition.
  2. In normal circumstances, you invest in a debt fund, the fund invests in debt securities. However today, due to COVID and the Franklin Templeton debacle, existing investors are scared and resulting in unusual redemption(sell) requests with the funds. So now because the funds don’t have all the idle cash in the world to entertain the requests, they will use the new investors money to fulfill the existing investor’s redemption requests.
    Even though Reliance offering their bonds at 10% is juicy, you can’t get those returns investing with Debt mutual funds, you’re better off investing directly with Reliance.
  3. Pricing is an issue. There are 10s of bonds offered by Reliance at times, whereas there is only one kind of Reliance share that is traded in the markets. If the share trades at 1460 you know that’s your price and that’s what you’ll get. But it’s different for debt bonds, they’re relatively very illiquid and thus, the pricing gets really complex.
    We use a method of comparables for valuing these bonds. If the exact bond I hold trades in the market today, well and good, pricing is easy but if not, you look at comparable bonds of comparable companies (similar credit rating, similar industry, etc.) to interpolate.
    In times like today, when everyone is running for safety and making redemptions the pricing can be quite off. Due to a huge sell off, the prices tend to be much lower. While this is similar to equity, it’s not what happens in FDs.
  4. The third disadvantage is that there are multiple unreliable layers and packaging in a single bond which the general public tends to ignore.
    For example – The investors of the shuttered Franklin Ultra Short Term Bond Fund will take longer than 5 years to get their money back, but as we learnt earlier Ultra Short Term means between 3 to 6 months of duration. An investor would’ve thought they would be buying 2 to max 8 months of bonds, and they’ll take maybe 8 months to get it back. They gave you a 6 months duration based on a smart form of financial engineering which is correct only on paper.
  5. The liquidity that your investment states is not that accurate. The credit risky funds say you can redeem your investment any day but they’re actually investing in illiquid, long term bonds repackaged as liquid funds, and are still being called short term investments.
    You can only redeem your investments if there’s a demand for the same. There is usually a good demand for government bonds because they’re liquid and the government can never go bust, but there is very little demand for the illiquid bonds that are also a part of the mutual fund’s portfolio (especially today). So, if 5% of the total money is invested in government bonds, redemption up to 5% is manageable but things get chaotic when there is higher than 5% redemptions. Similar is the situation today.
  6. There are also a few companies which run a Ponzi scheme of debts. These companies can’t comfortably raise debt from any other source, so they come to debt mutual funds. They’ll issue bonds to these MF secured by 2x the value of bonds, in shares. But they also tell these MF companies that they won’t pay regular interest but will pay lump sum at the end (say 3 years). Everyone is happy, except at the end of 3 years, the company now says I don’t have the money to repay, so I’ll issue you another bond which will cover the previous amount due and some extra. They keep rolling the bonds except when a time like comes and everyone wants their money and no MF is now willing to give them money and the Ponzi scheme stumbles. So, you have to make sure that your mutual fund is not a part of this or at least is not the only MF lending to such companies.
  7. RBI as a father. The banks that hold your FD have an obligation to put almost 20% of your FD into government securities, so the liquidity is much stronger. But even in an extreme unlikely scenario when FD withdrawals cross the limit the banks can always go to their father and borrow some money, no questions asked, the MFs in most scenarios can’t. However, taking the current situation into account the RBI is expected to step up.
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Thank you. That’s all for today folks.

You now know more than the banker who persuades you to buy debt funds from them.

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Moulik Jain
Moulik is 24, an Entrepreneur, and a successful Angel Investor at Beardo (exited). He is currently one of India's youngest Angel Investors.
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