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3 Types Of Debt Funds To Avoid Right Now

To ensure that your experience with debt funds isn't a regrettable one, avoid these types of funds right now.

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With the RBI surprising markets with an above normal 35 Bps rate cut in yesterday's policy meet, you might be considering an investment in debt funds again. Debt mutual funds have flummoxed retail investors over the past 3 years - with rising yields leading to negative returns from GILT funds in 2016, and then defaults resulting in quite a few shockers within corporate bond-oriented funds in the past twelve months. To ensure that your experience with debt funds isn't a regrettable one, avoid these types of funds right now.

Long term debt funds

With yields having rallied by 170 odd basis points since their 2018 highs of 8 percent, it may be said that the scope for a further fall in yields is limited from here on. In the event that yields stagnate or begin rising, long term debt funds such as most GILT oriented funds, may outperform. It is advisable to stick to the shorter end of the yields curve right now and invest into funds with a modified duration in the range of 2 years. It's also worth noting that the current spread between AAAs and G Secs are higher than normal, and any spread compression could result in better returns from shorter maturity corporate bond-oriented funds going forward.

Smaller sized funds

Smaller size debt funds face a peculiar risk in the current credit environment, which is challenging to say the least. When a particular bond gets downgraded, its liquidity dries up. At the same time, panicked investors start pushing on redemption requests, which the AMC is obligated to honour. Since there's no liquidity in the downgraded paper, they are perforce constrained to sell higher quality paper, thereby indirectly increasing the concentration of the illiquid paper.

Resultantly, these funds end up saddled with huge positions in papers that run a massive risk of defaulting; and when the risk materialized, they're sometimes forced to write off 30 to 50 percent of their NAV! In fact, this is exactly what happened in some funds from smaller sized AMC's of late. By the same logic, it would be a wise move to avoid debt funds from small AMC's as well, and stick with the haven of the heavyweights.

Funds with concentrated positions

Sites such as Moneycontrol and Valueresearch have made mutual fund portfolio related data easily accessible to all. Make use of this information! Instead of blindly trusting your Advisor (who may just be a newbie with a limited understanding of the dynamics of debt funds), quickly check the fund's total number of holdings as well as the concentration of the top holdings. Ideally, you'd want to invest into a debt fund that's diversified across at least 80 to 100 holdings, with any concentrated positions of 4 percent or more only being in sovereign backed holdings or heavyweights such as Reliance Industries. This rule would be especially applicable to credit risk funds that invest into lower rated paper.

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