Select Debt Funds With Caution

Mutual funds have been getting into a lot of trouble in recent times.

- Sudipta Mitu

Whether it is a company defaulting on its debt papers, a promoter getting into trouble because of pledging of shares, or companies unable to roll over their loans because of tight liquidity conditions each time a company gets into trouble, so do the debt mutual funds that hold its papers. In the light of these recent developments, it has become very important that investors choose their debt funds with care.

First of all, it is important to understand why debt funds are getting in trouble. They invest the money collected from investors in two types of papers -- government securities and corporate debt. Since government securities carry zero credit risk, they pay a lower rate of interest. If debt fund managers invested in them, they would have a difficult time beating even the returns from fixed deposits, and no one would invest in their funds. So, debt fund managers also invest in corporate securities. Banks too lend to corporates. And they have been struggling with the problem of non-performing assets (NPAs) for years now. Debt funds also lend to the same universe of borrowers. So, if banks are struggling with NPAs, it is not surprising that debt funds, who lend to the same entities, should also have their share of problems with borrowers.

The second issue is of investor perception. Many investors tend to think of debt funds as completely safe products. In fact, many even think of them as being as safe as fixed deposits, the only difference being that they offer higher returns and enjoy better tax treatment. These recent events will force investors to change their perception and evaluate the risks--both interest rate and credit risk--in debt funds more closely.

So, what is the advice to a new investor getting into debt funds?

The first is to