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The Curious Case Of Poor Returns From Debt Mutual Funds

Debt mutual funds invest the corpus in financial securities that pay interest. They don't invest in the stock markets.

Logically, therefore, the interest income should accrue and add to the fund. Consequently, the NAV of such debt funds should also increase correspondingly.

However, even though the interest rates have been around 6-9% in recent times, many debt funds have delivered only around 3-5% returns. This is particularly true for long-term debt funds.

Oops! Where has the money gone missing? Is there some fraud involved?

Well, the good news is that not a single rupee of this interest income has gone missing. There is absolutely no fraud or scam here.

If that be so, what's the mystery behind such low returns from long term debt mutual funds? More importantly, will I recover this so-called lost money?

Let's explore:

Debt funds invest the corpus in various kinds of financial instruments — e.g. government securities, bonds, debentures, commercial paper, certificate of deposit, structured obligation, etc. — issued by banks, public sector companies, state governments, central government and private companies.

One obvious suspect, in the low-returns scenario, is whether any of these entities have defaulted on the payment of interest and / or principal to the mutual funds. If yes, then the fund loses a portion of its corpus. This brings down the NAV, thereby impacting the net returns.

However, among the THOUSANDS of debt mutual fund schemes, ONLY 3-4 funds did encounter this "default" risk in last one year or so. Hence, their returns were affected. But this is a very (very) rare scenario. In last 20-odd years of mutual fund history, such defaults have occurred not more 10-15 times.

So, for all practical purposes, we can eliminate default as the reason for poor returns.

In fact, lot many people have lost capital in Fixed Deposits, but practically none in Debt Funds.

Wondering why your debt mutual funds have given such poor returns?

To resolve the mystery behind the recent poor show by long term debt funds, let's cut out all the noise and go back to the basic facts. Only then would we be able to clear the confusions, misconceptions and the fears that have been (needlessly) generated.

One. The fact that NAVs of debt funds have suffered a setback, has nothing — absolutely nothing — to do with the mutual funds per se. There is no fault, slip-up, gaffe or mistake on part of the fund managers.

Two. NAV of debt funds is calculated based on the prices of the bonds, debentures and other securities that it holds (similar to the NAV of an equity MF, which is calculated based on the prices of shares that it holds).

Three. Now, just as share prices fluctuate every day, the bonds prices too fluctuate every day. Since most people don't trade in debt and generally hold their fixed-income investments till maturity, they are unaware of these fluctuations.

Four. Fluctuation in bond prices is based on the day-to-day movement in the prevailing market interest rates. This relationship is inverse. If rates rise, bond prices fall. If rates fall, bond prices rise. Plus, this rise / fall in bond prices / fund NAVs is more for long term bonds / funds as compared to short-term bonds / funds.

There is a very simple mathematics behind it, which I had explained some time back. [See blog post 'You Can Lose Money Even In The Govt. Securities']

Five. In last 6-9 months, there has been a sudden spurt in market interest yields, as the RBI has not cut the policy rates as expected. This has affected all the debt funds; long term more than the short term funds. Hence, the significant under-performance.

Six. More importantly, as long as you continue to hold your investment in such debt funds, this under-performance could well turn out to be only notional. If the investment horizon is long term, there will be many such ups and downs in the interest rates. Eventually over a 3-5 year period, these will more or less even out. 

Seven. Also, you need to appreciate the fact that long term bonds offer higher “interest income”, in comparison to short-term bonds. As you stay invested, this extra earning from long term portfolio will improve the NAV of long term funds. Hence, you should most likely get your returns in the range of 6-9% p.a.; and that too with huge tax benefits.

Given the vast superiority of debt mutual funds over other fixed-income investments, one must build a well-diversified and balanced portfolio of various kinds of debt funds (this in addition to a well-diversified and balanced portfolio of various kinds of equity funds).

In this regards, you must know How To Select The Low-Risk High-Yield Debt Funds.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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