No, debt funds won't keep giving 10%+ returns!

An ideal investor in debt fund is one who is looking for more return than is being offered by bank fixed deposit. So, in a scenario, if the bank FD is giving a 6% interest pre-tax, the investor in debt fund is looking for anything above 6%. Tax benefits associated with debt mutual funds are an additional incentive for taking exposure to these funds!

If you have invested in a debt fund and read the market happening on a regular basis then you must have observed that the past 1-2 years have been quite eventful for debt markets! On one hand, the investors have seen defaults by companies like IL&FS, DHFL, Yes Bank, Vodafone-Idea, and lastly closure of schemes by Franklin Mutual Fund thus blocking thousands of crores of investors money. On the other hand, the one-year and two-year returns of various good quality debt funds are in the range of 11-12% which is around a third more than the 5 year average of around 8-9% (see chart).

Compounded Annual Returns of Debt Funds Across Categories

The one-year returns have brought cheer among the investors who have been stung by low equity returns (most negative over 2 years) and are putting money in debt to cut losses. While investment in good quality debt is definitely encouraging but most of the money that is flowing is based on the one year return. Thus, expectations are that the next one year will again be a repetition of the previous two years in terms of absolute return.

Investors need to understand that the aim of debt funds isn't to give you double-digit returns but to give you a return that is better than traditional bank deposits. Let's first understand the return components of a debt fund. The principal return component is the interest that the fund receives from the money that is lent to different companies, banks, governments, etc. The second component is the capital gain which comes due to interest fluctuations in the market. Eg. If a mutual fund lends money to a company at 10% at a time when the RBI repo rate* is 5%. If RBI on the day of its monetary policy review reduces the repo to 4.5% this will lead to a fall in the market interest rates. But the said fund has already got a commitment to get 10% from a company for a specified period. Thus, the fund will earn a profit because of holding a higher yield paper. This profit (loss in case interest rate goes up) is adjusted on a daily basis and is called the mark to market gain/loss or the capital gains portion of the return from a debt fund. In reality, the daily movements are based on the movements in the yield of government bonds. The quantum of the profit of such a move depends on the concept of duration about which we will discuss some other time.

Thus, the major reason for the sudden increase in the one year return is primarily the RBI rate cuts in the previous few months that has led to liquidity flush in the markets. This has been coupled with the government's relief package given to soften the blow of the COVID pandemic. With the repo rate at its lowest level, we can't expect any further rate cuts. This would mean no significant mark to market profits for debt funds. Thus, they will only generate interest income which will be passed on to investors!

To sum up, investment in debt funds with a quality portfolio is definitely a good investment decision but the goal should be to beat FD and not to mirror past year return. If you really want double-digit returns then try equity funds. With falling FD rates debt won't be giving you double-digit return unless the fund manager compromises on quality which may lead to another DHFL like fiasco.

*Repo rate is the rate at which the RBI lends money to commercial banks. A fall in repo rate means that credit is available at a cheaper cost thus leading to a decrease in market interest rates.