Debt Mutual funds too went through a torrid phase over the last few years lurching from one crisis to another, starting with credit defaults by ILFS and others, to the massive liquidity crisis for investors in Templeton debt funds. But like Infosys, lately debt funds have managed to stay away from controversies and negative media headlines. This is despite the mini “duration” crisis that hit debt funds in 2022.
Duration is the average tenor of a bond, in simple terms. Longer the duration of the bonds in a debt mutual fund portfolio, higher the fall in the market value, in a rising interest rate scenario. Debt funds provided paltry returns to investors in 2022, on account of a sharp increase in interest rates. As this was not unexpected, and a generic financial market phenomenon, the poor performance of debt mutual funds has not attracted media headlines.
2022 returns
Short term debt funds, banking and PSU debt funds, corporate bond funds etc. earned about 3.0-4.5%, when inflation during 2022 was raging at 6-7%, producing negative real returns.
A big letdown was dynamic bond funds which are expected to navigate such market scenarios. Returns were meagre, and in some cases close to 1%. Target maturity funds which made a big splash in 2022, suffered in line with other funds.
Black swan events for 2023
Inflation is like kryptonite for debt fund investors except in the overnight/liquid/money market and ultra-low duration category. While peak inflation appears to be behind us, there are other uncertainties with respect to inflation and therefore interest rates. Here are some of the known unknowns.Oil prices have an outsized impact on our economy, affecting current account balance, exchange rate of the rupee, inflation and interest rates. Commodity prices are notoriously difficult to predict. Investors may recall that in March 2020, oil futures turned briefly negative.
A black swan event for oil prices (and interest rates) could be the war in Ukraine taking a turn for the worse. Ukraine, with its war machine underwritten by the West, is unwilling to bow to Russian demands. For Vladimir Vladimirovich Putin, it would be a massive loss of face to compromise at this stage. The war may grind on for the foreseeable future with neither side making “progress”. But a humiliating Russian defeat on the battlefield in 2023 may force Putin’s hand to launch a tactical nuclear strike. This would have tremendous geo political impact, accompanied by a sharp increase in oil prices globally and interest rates in India.
Another less daunting scenario is fiscal profligacy in the forthcoming Union Budget in February. Any populist measure ahead of the central elections, which leads to an increase in government borrowings more than market expectations, could see interest rates spiking.
US interest rates impact interest rates in India. There is currently a tug of war between the US financial markets and the Federal Reserve. The markets are pricing in a rate cut by the Federal Reserve in 2023, while the Fed’s stance is “higher rates for longer”. If the markets find that their optimism is misplaced, in the face of a hawkish Fed, interest rates could spike in the US and India.
2023 returns could be better than 2022
Investors in debt funds can look forward to better returns in 2023, in an optimistic scenario devoid of black swan events. The current yield to maturity of funds with 2-3 duration is about 7.5% . While existing investors may recoup some of their capital losses of 2022, fresh investors may hopefully see capital appreciation too, when interest rates fall, along with inflation. Target maturity funds maturing in 2026, with yields of about 7.3-7.4% offer an opportunity to lock in yields at this level.
Debt mutual funds are tax arbitrage mechanisms
Both banks and debt mutual funds pool money from investors and invest on their behalf. It is difficult for debt mutual funds to earn higher returns than banks, for the same level of credit risk. Debt funds face significant disadvantages. Unlike bank deposits which are insured for Rs 5 lakhs, there is no such safety net for debt fund investors. Both banks and debt funds are exposed to credit risk. At banks, capital absorbs losses, and protects depositors. Debt mutual fund investors do not have this protection. RBI, as the lender of last resort, provides liquidity to banks, while mutual funds do not have this backing.
Debt mutual funds do not offer superior returns compared to banks, while lacking the safety net of banks. Despite this, the industry has grown into a 12 lakh crore behemoth today, largely thanks to tax arbitrage. Interest on bank deposits is taxed at the marginal rate, while debt mutual funds offer tremendous tax benefits, in the form of indexation and lower rate of taxation if held for more than three years. Any adverse change in debt mutual fund taxation, may decimate the industry.
Disclaimer: the contents of this article should not be construed as investment advice or tax advice.
(The author is a fixed income investor and erstwhile corporate banker)
