In this post, I will share some important information regarding debt funds and we will understand how much safe are debt funds
Types of Debt Funds
Where debt funds usually Invest?
Most of the debt funds invest in Corporate Bonds or NCDs, Debentures, Government or RBI Securities. Corporates borrow money for short term (few days) to long term (few years) depending on their requirement. They generally use this money for their day to day business activities or starting of a new project.
Out of all mentioned instruments, RBI and government securities considered to be safest and generally give a yield (return) of 5-8 % over a horizon of 3-5 years.
Read: More on debt funds here
All economics goes through their various up and down cycles and generally most debt funds easily give 5-8% return (1 Year).
But when the economy goes through a down cycle like recession which is once in a decade event, the principal is usually is at risk in most of the debt funds.
Let’s take the example of a fund.
HDFC Credit Risk Debt Fund
Credit risk funds invest in corporate bonds that are rated AA and below with a minimum exposure of 65% in such securities. Therefore it gives more return compared to other debt funds on account of the risk it takes.
There is always been a trade-off between risk and reward. The greater the risk one takes, he/she is entitled to a greater return.
But what happens when things go south.
Have a look at a snapshot of the portfolio this fund
As we can see this fund holds security issued by companies such as Tata Motors, Tata Steel & Vedanta.
As we have already seen above-mentioned companies have a huge debt pile and already undergoing huge pressure. And there could be an event under the extreme conditions the company may not able to fulfill its obligation. (Payment of interest + Principal). Therefore there is a considerable risk involved in this fund.
Since the beginning of Feb 2020, all world markets are bleeding due to fear of Corona-virus. Under such conditions, Most of the investors try to move to safe heaven instruments and generally cut exposure to risky debt funds.
Below is the 1-year return of the HDFC Credit risk fund.
As we can see the trailing 1-month return is -2% for this fund. Because the fund invests in riskier securities. I understand that one generally invests for a longer time horizon but still if things don’t improve an investor might lose a year return also.
Generally, a fund invests in investment-grade securities (AAA to BBB-) but some times they do invest in low-grade securities (Case of Vodafone idea debt paper).
Therefore it is always advisable to not consider debt funds the same as bank fixed deposits. There is a reason they are able to give better returns compared to banks and one should always consider that.
Things to consider before investing in debt funds
- Investment Horizon like short term (less than 3-6 months) should avoid any debt funds.
- Invest in debt funds only after checking the fund portfolio, not the past returns.
- One should avoid Credit risk and Gilt funds for the short term. (less than a year). Note, not all credit risk funds are worth investing, some could be highly risky and even destroy your wealth.
- Fund size, considering redemption from investors, fund size less than 1000 crores should be avoided.
References
Investing in Debt Funds
HDFC Credit Risk Debt Fund
