Decline In Returns From Debt Funds; What Should An Existing Investor Do?

During the COVID crisis last year, central banks across the world, including the RBI, cut interest rates significantly to help create financial space and flushed the system with liquidity, lower the cost of borrowing where possible, and empower individuals to spend more. As the rates lowered existing investors gained on a mark to market basis. However, over the past year, economic recovery has made significant headway. As we move out of 2021 and into a truly post-pandemic world, the RBI faces the new challenge of pushing interest rates back to a sustainable level to manage price rises. This, however, will have an impact on returns from debt funds.

Investors often look at debt funds as absolute, sure-fire options. It’s important to note that, while debt funds do have a great degree of long term stability and more consistent returns than, say a mutual fund exposed to stocks, there is still a degree of play associated with them.

If you’re planning to invest in a debt fund or already have, it’s a good idea to understand how the ongoing debt fund dip can affect your investment strategies. We’ll be taking a closer look in this article.

What’s Going On With Indian Debt Funds?

Before considering what you need to do - the options in front of you with regards to your debt fund portfolio - it’s important to understand exactly what’s going on with debt funds in the aftermath of the RBI’s interest rate hike. Debt fund Net Asset Value has an inverse correlation to the central bank interest rate. So if interest rates rise, Net Asset Values will fall & vice versa. This is a deviation from the normal perception of fixed income products where we feel that we are going to get fixed returns all the time.

If you’re already invested in a debt fund or are planning to do so, what are your options in this case?

Holding Till Maturity

For conservative investors who plan their long term portfolio with fixed returns in mind and a fairly low appetite for volatility, the best course of action right now might be to see your debt fund investment through maturity. Interest rate swings just don’t matter because regardless of them you’ll be getting the same fixed returns expected ceteris paribus

If you hold your portfolio till maturity and interest rates rise, there’s an opportunity cost involved where you could have deployed money at a higher rate of return.

Exiting Early, But At What Cost?

Your principal will be marginally lower on account of higher rates, and a penalty will likely be imposed for an early exit. It makes sense to keep these factors in mind and then weigh the costs against the returns on shorter-term, higher-return investments like ETFs, factoring in

risk as well. Whether pulling out of a debt fund makes sense or not depends largely on your risk appetite and your timeframe for realizing returns.

With interest rates going back up, at least in the short to medium term, Indian debt funds returns will see a dip. This will mean potentially lower returns for those looking to exit early and a possible opportunity cost for those intending to stay on till maturity with longer duration funds. There isn’t one optimal way to respond to this particular situation.

What we’d advise is to ensure that your investment fundamentals are sound - take actions with regards to your debt fund investment in line with your risk appetite - hang in there if you’re looking at consistent long term returns

Most importantly, though, ensure that you have a balanced portfolio in which instruments like debt funds are part of a whole, alongside other instruments like bonds and alternative investment classes such as real estate and agriculture. What’s important is that your portfolio is closely aligned with your overall financial goals. If anything, the dip in debt funds returns today tells us that it's critical to have a balanced, well-aligned investment portfolio.

The author is the co-founder of Wint Wealth. 

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.