Debt mutual funds yet to regain investor attention
Debt mutual funds have delivered returns of 8–12 per cent over the past 12–15 months, with performance across categories being robust. A combination of factors such as peaking of interest rates, the government’s sharp focus on containing the fiscal defecit and borrowing program, inclusion of Indian bonds in global indices and controlled inflation levels meant that g-secs of longer maturities (10 years and higher) rallied strongly and yields were down 43-50 basis points in 2024.
Not surprisingly, long duration and gilt funds that invest in such longer maturities did extremely well. These categories were the best performers in 2024. At the shorter end of the curve, the liquidity was in deficit till April 2024, went into surplus for about six months, before getting into the deficit territory again late in the year. So, short-term yields were high. So, money market, short and low duration categories delivered strongly.
Even though debt mutual funds have delivered returns of 8–12 per cent over the past 12–15 months, investors have yet to restore their attention to them. According to the industry body AMFI, the total number of debt fund investor folios has been decreasing constantly, from 80 lakh four years ago to 68 lakh now.
Additionally, the growth of the Assets under management (AUM) of the category has not painted a favourable picture. Over the last seven years, the AUM of the debt category grew just 40 per cent to ₹15.8 lakh crore, while the equity funds category grew by 387 per cent to ₹41 lakh crore.
Debt mutual funds used to be a well-liked option for conservative investors because of their tax-efficient returns in comparison to fixed deposits. Due to quality problems and the elimination of the indexation tax incentive, they lost their appeal to investors. The persistent equity market rally too made the fixed income investment less attractive.
Challenging periods for debt funds
For debt funds, the past six to seven years have been difficult. Things became worse ever since the IL&FS crisis triggered a wave of bond defaults in 2018, and later. An exposure to stressed assets of the companies like IL&FS, ADAG Group, Essel group and DHFL led to capital erosion for the debt funds that they held. The situation further worsened when the Franklin Templeton India mutual fund decided to shut down six debt schemes due to illiquidity brought on by the pandemic.
However, many debt schemes were later able to collect the money owed on troubled assets. Franklin Templeton, too, returned 109 per cent of the assets to the unit holders of six shuttered debt schemes.
The removal of indexation benefits in debt funds effective April 1, 2023 further added woes. As a result, capital gains from the sale of debt mutual funds are now taxed at the investor’s applicable income tax slab rate.
Asset quality improves
However, things have changed of late. The asset quality of the debt funds improved as a result of the strict requirements enforced by market regulators and internal fund house mechanisms.
Most of the debt schemes other than credit risk funds pruned their exposure to lower rated bonds significantly. Compared to 13 per cent seven years ago, the aggregate debt funds’ allocation to debt instruments rated below AA has drastically decreased to two per cent as of December 2024.
A compelling asset diversifier
Even without the indexation benefits, the debt funds are still an attractive option compared to bank deposits as there are no penalties for early withdrawals.
Debt mutual funds play an important role in an investor’s portfolio that not only mitigate risks through asset diversification but also generate regular income. They proved to be an asset diversifier during the equity market turbulent bear phases, just as in the crises of 2008 and 2020.
Debt funds are mostly used to meet short- and medium-term goals, like an emergency corpus or a corpus to pay for immediate expenses such as a down payment for a car loan. They can also be part of the long-term portfolio. Long-term investments in debt funds not only reduce volatility but also ensure higher consistent returns.
During a bull market run too, the investors should not ignore debt funds since they might provide attractive returns.