Debt funds are hurting, but fund houses are fine

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Interest rate hikes by the Reserve Bank of India are roiling debt funds. Over the past year, most have delivered returns in low single-digits and their assets under management are down 2.5%. Indeed, the grim near-term outlook on interest rates should be bad news for fund houses as their income depends on the amount of assets they manage. However, this time, equity funds are proving to be a stable counter to weather this turbulence.

Debt instruments carry a fixed interest rate, but that gets diluted in a mutual fund portfolio, where they have to be marked to market continuously. Thus, when interest rates in the economy rise, prices of existing debt paper fall and, by extension, the net asset values (NAVs) of debt funds invested in them also fall. Typically, the longer the tenure of a debt paper, the greater the impact. This century, there have been four phases when interest rates have risen for significant periods. The longest and most pronounced was between March 2004 and July 2008, when the yield on a 10-year government bond rose from 5.2% to 9.3%. The current increase so far is about half in both duration and extent.

However, there’s one difference. In the previous three periods, assets managed by debt funds rose, along with an increase in overall mutual fund assets. This time, assets managed by debt funds have dropped or tapered, even as overall mutual fund assets have increased. Companies and high net worth individuals (HNIs), who are the majority investors in debt funds, expect interest rates to maintain an upward bias.

Negative outlook

Between December 2021 and August 2022, the latest period for which data on mutual fund assets is available, the 10-year G-sec yield has increased by about 0.9 percentage points. During this period, assets managed by debt funds increased by just 3% . Industry grouping Association of Mutual Funds in India (Amfi) puts out data on 17 categories of debt funds. Of these, assets of 11 categories fell, mostly in the medium- to long-tenure segment. This is also reflected in returns. According to Value Research, the average one-year return was just 1.3% for long-duration funds and 3.4% for medium-duration funds.

Assets managed by short-term categories fared better. Assets in overnight funds increased 13% and in liquid funds by 14%, with perceptible jumps in August . What this suggests is that the medium- to long-term outlook in interest rates remains bearish and the greater expectation among market participants is that the interest rate trajectory in this band remains difficult to predict.

Investor diversification

Fund houses have reason to feel more comfortable about maintaining their assets levels than they did previously, despite the negative outlook on one of their key pillars. The industry was opened to private players in 1993, but for much of this time it was corporates and HNIs who led in participation. Companies invested their surpluses mainly in debt funds to protect their principal while earning more than with a bank deposit and enjoying high liquidity.

Thus, in each of the three periods of July 2005, July 2010 and July 2015, the share of debt funds in total mutual fund assets ranged from 66% to 69%. This changed during the pandemic, as retail investors flocked to equity and equity funds. Since July 2020, mutual fund assets have grown 39%. The share of debt funds fell from 51.5% to 33.5%, with equity funds mostly capturing the gains. Fund houses have come out of the pandemic with a more diversified investor and asset base.

Containing losses

Mutual funds will like this diversification in investor base. Retail investors tend to be stickier than companies and HNIs. As they also invest mostly in debt funds, they can also be more responsive to markets. It is a testament to this diversification that this year, when both debt and equity have endured significant challenges, mutual funds have held onto their assets.

Their average assets under management in 2022 increased 4% until August. Overall assets under debt funds have risen 3% , while those under equity funds rose 10%. A debt-equity split is not available for individual fund houses. At an aggregate level, though, 22 of the 42 fund houses saw their assets decline. Among the top 10 fund houses by assets in June 2022, only SBI Mutual Fund added assets. The others saw an erosion, but of up to 7%. In these turbulent times, they will probably take that.

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