Playing It Safe

How to minimise interest rate, credit and liquidity risks in debt funds

- APRAJITA SHARMA

If liquid and short-term debt funds gave negative returns in March 2020 when the Franklin Templeton fiasco was on in full swing, duration funds turned negative in March 2021. Most debt schemes with long-duration investments, which had delivered double-digit returns in 2020, are back at single digits now. Experts blame volatility in bond yields for such a high variation in returns in the short term.

Debt funds are considered safe as they hold fixed-income securities. However, as the above examples show, this is not true. “Debt mutual funds are subject to mark-to-market valuation on a daily basis due to yield fluctuations which, many times, may lead to negative returns in the short term. However, this is a short-lived phenomenon as, over a longer period, you should generally earn what was the yield-to-maturity at the time of your investments unless there are some defaults in the underlying portfolio,” says Raghvendra Nath, Managing Director, Ladderup Wealth Management.

Apart from these risks, the debt fund universe is complex, with as many as 16 categories. The performance of each category depends on the interest rate cycle. When interest rates rise, short-duration funds such as liquid and ultra-short-term funds do well, but long-duration funds turn risky. The opposite happens when rates are falling. Since interest rates were falling, duration funds such as gilt funds were giving double-digit returns in the first part of FY21. A different story will play out in FY22 as the yield curve rises.