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Lost Capital In Fixed Deposits: Many. In Debt Funds: None.

At last, Indian investors have realized the huge benefits of investing in mutual funds.

Massive inflows, into the mutual fund schemes every month, amply prove this point.

Of course, we still have a long way to go. But, at least, a decent start has been made. As they say ‘The journey of a thousand miles begins with one step’.

Given this, it is important that this new-found trust in mutual funds is not broken by misconceptions.

Certain incidents in recent past, have created doubts in the aam investor’s mind.
a) Sharp fall in the NAVs of a few debt funds due to some investment going bad
b) Depreciation in the NAVs of many (long term) debt funds

These must be appropriately addressed.

Yes, the NAVs did fall. After all, NO investment is 100% risk free.

But, it doesn’t mean that you have to avoid Debt Funds and go back to Bank Fixed Deposits. No, that would be a blunder. Don't let blind faith in fixed deposits harm you.

Because...
... FDs are only perceived to be risk free; actually they are not. Tax and Inflation often cause big loss in its purchasing power, even though the capital may appear to be safe and growing.
... Debt funds are infinitely better than FDs, as comparatively the risks are insignificant and the (post-tax) returns lot better

The investment mantra therefore has to be 'Risk Protection', not 'Risk Aversion'.

Debt mutual funds primarily face two types of risks viz. Default Risk and Interest Rate risk.

What is Default Risk and How to Manage it

This is simple. We all know what Default Risk is. 

You may not have personally lost money in a dubious and extravagantly high-interest fixed deposit. But you probably know someone who has, or have at least read about it. It’s that common.

Many people have dud Fixed Deposit receipts, with practically no hope of recovering their capital; interest, of course, being a total write-off. However, NO ONE HAS LOST HIS CAPITAL IN DEBT FUNDS.

People are often attracted to high interest-rate deposits. Especially, in days like the present times, when bank interests are dropping fast to new lows.

Debt funds are the ideal way to minimize the Default Risk as compared to Company / Co-operative Bank Fixed Deposits.

Why?

debt-mutual-fund-or-bank-fixed-deposit
There's simply no debate that Debt Funds are lot better than Fixed Deposits.

First, naturally, is the benefit of diversification. On your own, you would invest your capital in at best a few deposits. So, even one default would create a big dent in your capital.

Mutual fund corpus, on the other hand, is invested across many companies. Even if there are a few defaults, it may at most wipe out only the interest earned or a minor part of the capital. In other words, diversification protects your capital from a TOTAL LOSS.

Second, of course, is the fund manager’s expertise. You, as an amateur, are unlikely to spot shady deposits. Professional and experienced fund managers rarely make such mistakes. This is proven by the fact, that there are barely 5-7 instances of default or downgrades in the investments made by the mutual fund schemes, over the last 15-18 years of active mutual fund history (and these were business failures, not dubious schemes). BUT, NO MUTUAL FUND SCHEME HAS ITSELF DEFAULTED TO ITS UNIT HOLDERS.

But even this small risk of "investment" default can be brought down to near-zero levels.

How?

a. Choose a fund with large corpus say more than Rs.3000-5000 crores. Such funds would be extensively diversified. So the impact of default, if any, would be so limited that you may not even feel it. The schemes that suffered steep fall in their NAVs were mostly around Rs.100-200 crores in size. Hence, the impact of downgrading was sharp.

b. If you want to play ultra-safe, you can choose funds that invest mainly in Govt. Securities and Public Sector Companies. I hope the Govt. won't default.

What is Interest Rate Risk and How to Manage it

Interest rate risk is nothing but simple mathematics.

However, given that many people dread maths, I will not go into the calculations involved. Interested readers can read my earlier blog posts in this regards:
Why Gilts (and bonds) are prone to interest-rate risk? and
How To Become RICH: Replace 'SK' In 'riSK' With 'CH'.

Let me simply summarize how the interest rate movement impacts your investment in debt funds.

- NAV of a debt mutual fund is calculated based on the bond prices
- Bond prices, on any given day, are derived from the market interest rate
- If the interest rates go up, bond prices fall (that’s maths). So NAV too falls.
- If the interest rates go down, bond prices rise (that’s maths). So NAV too rises.
- Long maturity bonds rise or fall more vis-à-vis the short maturity bonds (again maths)

Given these facts, you should invest in…
… long term debt funds when the interest rates are in the declining trend
… short term / ultra short debt funds when the interest rates are rising
… dynamic bond funds if you don’t want to track interest rates and let the fund manager take the call

Few weeks back, almost everyone was expecting a rate cut by the RBI. So many debt funds had moved the investments to long-tenure bonds. RBI, however, not only decided against any rate reduction, but also ruled out any cuts in the coming months. This led to sudden rise in the market interest rates and hence reduction in bond prices / NAVs

Having said that, such rise or fall in NAVs, is notional. Only when you sell, does it become the actual profit or loss. So, if you hold your debt mutual funds for long term — at least 3 years, which is required so as to benefit from the lower tax on long term capital gains — the interest rate will go through many such cycles. Therefore, sometimes the NAV will appreciate, and sometimes it will fall. This volatility in NAVs will eventually more or less even out.

Hence, on a long term basis, interest rate risk is practically no risk at all.

Before I conclude, I have a sincere request:

Don’t hesitate to consult a financial advisor [of course, not me :-) ]. 

In your endeavour to save a few thousand rupees on his / her fees, you are unnecessarily jeopardizing your investment running into lakhs of rupees.

Don’t be penny wise, pound foolish!

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