Should You Be Going Back to Traditional Investments Now?

May 09, 2020

If you recall reading my colleague, Divya's article, COVID-19 Related Disruption Causes Franklin Templeton Mutual Fund to Wind-down Six Debt Schemes, you would have felt the lightning jolt to remind you again, Debt mutual fund investment isn't risk-free at all.

The illiquidity faced by the fund house led to a big step of closing down of six schemes, sheds lights on:

  • The risk the fund managers took to earn better returns

  • The amount of exposure of the schemes that held toxic papers or downgraded instruments

  • Investors hard-earned money jeopardised...

Investors who had invested in those six schemes are left in a lurch and stand to lose their capital.

Debt mutual fund investment was meant to be less risky than equity mutual funds due to the excessive market volatility, and suitable for moderate to risk-averse investors.

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Currently, a challenge for investors is where to invest, the need for cash is important and to earn some returns as well. Due to the pandemic situation, the markets are frenzied making equity investments risky for a short time frame. Debt mutual funds also have proven to be a bad choice of investment, which has amplified credit risk, if you recall I wrote to you about it.

The erosion of wealth due to the continued debt crisis coupled with a slowdown in economic activity and sharp fall in markets has baffled investors, making them look for a safe basket of capital preservation.

Investors are now thinking of following their elders' conservative investment approach to invest in bank fixed deposits. After all, there are five good reasons to invest in a bank FD:

  1. Fixed and secured returns, unlike market-linked instruments;

  2. Addresses liquidity needs (if the plan and tenure is thoughtfully selected);

  3. Addresses short-term goals and contingency requirements;

  4. Can take a loan against bank FD when in dire need of money; and

  5. A 5-year tax-saver bank fixed deposit can help in tax planning as well

 

Fixed deposits, is one such avenue that guarantees a steady, regular source of income with the safety of principal, despite the low interest earned. Hence, if you wish to take care of liquidity needs and address short-term financial goals, investing in bank FDs could be a good option.

FDs are suitable only if you are about to retire or you are about to accomplish your investment objective within a few years or so, that time your focus would be on capital preservation.

But FDs are not that tax-efficient, as the interest earned is subject to the Income Tax Act and it does not provide inflation-adjusted returns.

While the hostile credit environment the debt market is experiencing at the moment, it would be imprudent to ignore the default risk involved in debt funds. The common notion was that only long-duration funds are subject to the risk of default has changed. Instead, the Coronavirus flu the markets have caught has crushed the investors' confidence.

What should investors do?

The RBI has taken measures to address the liquidity needs of the mutual funds and the Regulators have decided to become more strict with the way the debt mutual fund portfolios are going to be created.

[Read: RBI Steps in to Take Some Pain Off Mutual Funds. Will It Help?]

Investors have to be extremely careful, tread with caution. Remember fixed deposits do provide safety, but aren't tax-efficient if you are in a higher tax bracket; so the returns would be less and cannot beat inflation. If you want to invest with a short-term investment horizon, consider liquid or overnight funds.

  •  Liquid funds

    Liquid funds are open-ended debt mutual funds that primarily invest in short-term money market instruments with maturity up to 90 days. Liquid funds invest in money market instruments such as Certificate of Deposits (CDs), Commercial Papers, Term Deposits, Call Money, Treasury Bills, and so on. Liquid Funds due to high liquidity are better than bank FDs because they carry the potential to generate inflation-adjusted returns. In financial parlance, it's known as the real rate of return.

    But a lot depends on selecting the best funds, as they do carry high risk given the market-linked nature of liquid funds, the return potential hinges on market conditions, and how efficiently the fund manager manages the portfolio.

    So, consider liquid funds only if you are open to taking credit risk to a certain extent. Otherwise, overnight funds can be an alternative.

  • Overnight funds

    It has the shortest investment duration of one day and provides better returns than bank FDs and it has higher liquidity. The interest rate risk involved therein is near zero. However, there can be a reinvestment risk, i.e. overnight funds may not be able to reinvest their proceeds at the same rate of return, but at least that doesn't cause any capital erosion.

Thus, it is suitable for conservative investors who want to park their money for one month or less than a year.

However, the most important aspect of selecting any fund is you approach even short-term funds with your eyes wide open and paying attention to the portfolio characteristics and quality of the scheme. Prefer safety of principal over return. Stick to mutual funds where the fund manager doesn't chase returns by taking higher credit risk. Further, asses your risk appetite and investment time horizon while investing in debt funds.

As a thumb rule: Choose mutual fund schemes from fund houses that follow prudent judicious investment processes and stringent risk-management systems.

Our friends at Quantum Mutual Fund have highlighted the secret behind their debt management strategy, which has helped them provide safety and liquidity to investors when it comes to investing in quantum funds. Don't Worry, Quantum Liquid Fund always aims for Safety and Liquidity.

As with all financial matters, better safe than sorry!

 

Warm Regards,
Aditi Murkute
Senior Writer

 

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    raniresoria@gmail.com | May 09, 2020
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