A financial advisor friend highlighted a strange dilemma. Over the years, mutual funds have advised investors that debt funds come with moderate risk. Short-term and medium-term debt funds can replace fixed deposits due to tax efficiency.
Mutual Funds managed assets worth Rs 23,00,000 crore as of January 2019, according to the data from the Association of Mutual Funds in India or AMFI, the industry body. Over half of this money is in fixed income funds like debt or liquid funds. A sizeable share of that money is from businesses as they park short-term surplus for tax efficiency.
A shocker was in store for debt fund investors in some of the leading mutual funds. There was panic in the market over the debt repayment ability of a few companies. Prominent among them was the Essel Group, promoted by Subhash Chandra of the Zee Network. Mutual funds have subscribed to bonds, and the debt is backed by pledging shares of Zee Entertainment, another listed company.
While it is clear that there is no chance of default now, there was panic among investors for a brief period. The financial advisor friend said that all the while they talk to their clients about putting money into short-term debt funds instead of fixed deposits. If any company defaults in the future, this could shake things up. The friend is right as a financial advisor will not have any real-time information.
The argument that the friend made was that when people invest in equity, they expect an element of risk.
They are prepared to take chances. However, when it comes to fixed income, people do not foresee any losses. If any company defaults on the repayment or servicing the interest and the debt portfolio of that mutual fund loses value, investors too may see erosion in their investment worth.
Fixed income funds are of various types. There are liquid funds that are low duration funds with a portfolio of maturity of fewer than 91 days. According to the AMFI literature, these are a good alternative to the savings bank account and offer a better post-tax return.
The short-term or ‘ultra’ short-term debt funds hold a portfolio with a maturity of three months to under three-year duration. The Amfi literature says that these are good investments for short-term investors looking to park surplus funds and offer better returns than liquid funds.Now, if the portfolio they hold loses value due to a sudden default by a company, it can hurt the short-term returns of investors.
What you should do
There is no need to panic. In case of debt funds, portfolio erosion will not happen suddenly. When a company is unable to pay up, a process gets triggered. Company promoters negotiate with lenders to work out a solution. Usually, promoters bring in more money or other guarantees to ensure that portfolios of investors do not get eroded. A situation where the bottom may fall from your fixed income investment is a highly unlikely scenario.
You may also want to discuss your doubts with your financial advisor. It is always a good idea to read up more about your investments. A panic situation occurs when you do not know much about where your money is.
The best way to deal with such a situation is to read up all the literature you can find. A discussion about the sequence of events with an advisor or knowledgeable friends can also help subside the panic situation.
The situation should help you appreciate the concept of risk in the market. While we have dwelt extensively on the aspect of market risk in the equity segment, there is an interest rate risk and a credit risk in debt funds.
There is no reason to panic and lose faith in investing or financial assets. The last thing you should do is take money out of financial assets and put it into real estate and gold. You can only minimise risk by spreading your investment across asset classes through diversification. You cannot eliminate it.