Debt Fund Returns – Setting the Right Expectation

In debt mutual funds, there are two legitimate risks that can be taken to improve returns

• Credit Risk – via higher exposure to borrowers with lower credit quality – implying higher borrowing rates and thus higher returns (assuming all is well and the borrowers don’t default or get downgraded. Last few years provide a glimpse of what can happen when this assumption fails)
• Interest Rate Risk – via lending for a longer duration – if interest rates come down then you end up with higher returns (and vice versa)

Most of us use Fixed Deposit returns as a mental benchmark to gauge returns that can be made with the lowest risk and least effort.

A Fixed Deposit technically has no interest rate risk (as the interest rates are fixed) and very low credit risk (at least up to Rs 5 lakhs and assuming you are invested with a large reputed bank).

So the closest proxy to fixed deposit via debt funds would be – High-Credit-Quality Funds with Low-Interest-Rate Risk. This essentially means debt funds with ~100% AAA exposure and a modified duration of less than 3 years.

Let us see, how this low-risk debt mutual fund strategy has played out over the past few years:

These are definitely respectable returns. Add to it the flexibility to exit anytime and the tax efficiency (vs FD) if held for more than 3 years.

So most of us, rightly so, are comfortable with ‘High Credit Quality Shorter Duration Debt Funds’ as a better alternative to FDs given its good returns, lower tax implication (if held for >3 years), and exit flexibility.

If you are an investor getting into ‘High Credit Quality Shorter Duration Debt Funds’ now, it is natural to be anchored to the past returns of around 7-8% and expect similar returns going forward from this strategy.

However, here is where we think, the past can slightly mislead you and there needs to be a reality check on your future return expectation from ‘High Credit Quality Shorter Duration Debt Funds’.

Setting the Right Return Expectation…

While debt funds are made to look complicated, if you peel away the layers, in effect, all that you are doing is lending your money to a number of borrowers (companies/government/financial institutions) indirectly via a debt mutual fund.

The returns of your debt funds to a large extent will depend upon the interest rates that the borrowers pay to borrow indirectly from you. This aggregate rate at which they borrow from the fund is called Yield To Maturity or YTM in financial jargon.

No doubt, I am oversimplifying some nuances. But stay with me, and I got you covered on this.

So ideally the YTM should be your returns from any fund right?

Correct. But just a small nuance.

Debt Mutual funds don’t do this intermediation for free and charge us a small cost called expense ratio for going through the hassles of evaluating borrowers, lending, and collecting money from them.

So YTM-Expense Ratio which we will be referring to as Net YTM can give us a good idea about the returns to expect going forward. (just an additional nuance –  the interest rate movements can add/reduce returns over and above the Net YTM and the degree of impact will be dependent on the modified duration of the fund – the higher the modified duration higher the impact)

What is the trend of YTMs in the last few years?

The YTMs of debt funds have been gradually coming down over the last few years.

What is the current YTM?

This has an important takeaway for us:

– For the same low-risk debt portfolio that you had earlier, your return expectation has to come down since the YTMs have come down.

– As the net YTMs have come down by around 1-2% your return expectation should also come down by ~1-2%. 

This is in line with the falling inflation trend in India. While Inflation for the last few months has seen a sudden increase, however, RBI expects this to come down over the next 3-6 months.

Similar to how YTMs have fallen in debt funds, Fixed Deposit Rates have also followed the same trend implying lower future returns for FDs as well.

Once we understand this new scenario of slightly lower expected returns from debt funds and Fixed Deposits (compared to the past), we have two ways to respond to this

2 Approaches to your Debt Portfolio…

Option 1: Increase the Risk to target Higher Returns (which we got in the past)

Risk can be increased in three ways to target slightly higher returns

• Credit Risk 
• Interest Rate Risk
• Add some bit of equity allocation to the mix

Now the key thing to remember is that in the future if the risks don’t play out you end up with higher returns and you are super happy. The flipside is that ‘risk’ can also play out in which case you will have to be ok with far lower returns.

Option 2: Stick to the same low-risk option and reduce return expectations

In this case you decide to stick to your original low-risk profile and stick to high-quality-shorter-duration debt funds. You are comfortable with the lower return expectation but you are not willing to take up the headache of credit risk and interest rate risk.

Thinking through the Choices…

The difficult part of making a choice is that, as with most things in life, each one comes with its own set of tradeoffs.

1. If you take credit risk to improve returns, there is a possibility that some credit event plays out and there is a run on your fund (remember the Franklin Templeton incident) – you might end up with much lower returns and several headaches in this case
2. If you take interest rate risk, and unfortunately interest rate cycle turns and yields start inching up, you may end up with much lower returns than the simple high credit quality shorter duration option
3. If you take low risks via simple high credit quality shorter duration funds, you will have to be ok with two scenarios where

a. If interest rates go down further you will underperform gilt/income/dynamic funds segment

b. If credit risk events don’t play out you will underperform credit risk funds

You will have to think through each of these risk-return tradeoffs and finally, own your choice and live with the outcomes (which will only be clear in retrospect).

After a year or two when you look at the outcome, it will seem like it was the only obvious outcome. You will most likely not remember the underlying tradeoffs that went into each of these choices and various possible outcomes that could have translated.

This can lead to the regret of not having chosen an alternate path.

So the idea of this post is to remind you that this is how messy, real-life decision-making looks when you are dealing with the future. The outcomes are never as clear as what it seems in retrospect. Whatever be your decision, stick to it and don’t regret down the line if in case some other alternate strategy (with higher risk) does better than your choice.

This might sound a tad too philosophical, but the thought process we went through is exactly what ‘risk management’ looks like when applied to real life.

What is our Approach?

We have always believed that you should start with deciding on the risk you are comfortable with and then set potential return expectations for that level of risk rather than the other way around!

We have been advocating a core-alpha allocation for debt portfolios (read here). This simply means that you pre-decide on your safe high credit- shorter duration debt fund exposure. This is called ‘core bucket’ and should form the majority of your debt portfolio, say 70%-100% of your debt allocation. For investors willing to take higher risks for improving returns, 10%-30% of the debt allocation can go into higher risk strategies. This is called ‘alpha bucket’ and should form a small portion of your debt allocation (if only you really need it).

Whatever was your original planned core-alpha debt allocation mix, continue with the same mix. Don’t alter your original debt risk profile to chase returns. For eg, if core bucket allocation was 80% and alpha bucket allocation was 20% of your debt allocation, stick to the same allocation.

Even within the Alpha bucket,

• Avoid Credit Risk
• Play via either Dynamic Debt Funds (dynamically increase/decrease the duration of the fund to benefit from interest rate movements) or Debt Oriented Hybrid Funds (Equity Savings Fund, Balanced Advantage Funds)

Down the line in a few years, as past risk via credit events and interest rate volatility are forgotten there will most likely be a temptation to increase your alpha allocation within your debt portfolios. It is important to resist the lure and stick to your original debt risk profile (read as core-alpha mix).

If you haven’t decided on your core-alpha debt allocation yet, now is a great time to do it.

Summing it up

Future Return expectations from both debt funds and Fixed Deposits need to be slightly lower compared to the past.

While this might lead to a temptation to increase the risk in order to target higher returns, we would caution against this approach. Focusing on return targets and then deciding on the risk to be taken (core-alpha debt portfolio mix) seems to miss the entire point of risk management.

For any investor, the risk taken should ideally not be the result of a return target. Returns, by contrast, should be the byproduct of a sensible investment strategy and a clear understanding of risk being taken.

In line with the above thought process, we continue with our preference for High Credit Quality Shorter Duration Debt Funds.