For years, millions of middle-class salaried Indians trusted debt as the investment instrument that lacked risk. The assumption was that the safest way to save and keep your money was by putting them in bank fixed deposits. If you wanted a little more return but did not want to take too much risk, company fixed deposits that were highly rated but offered a little more interest were good instruments. Over a period of time, however, the salaried class realised that most companies that offered interest rates that seemed too good to be true were exactly that. Too many companies failed and retail investors lost their appetite for company fixed deposits.
By the late 1990s, mutual fund managers started selling debt mutual fund as the perfect instrument for the risk-averse. By the turn of the millennium, its popularity had started rising. Even those who invested in mutual funds primarily to get the benefit of equity investing without the pain of researching and putting money directly into equities were told to have some holdings in debt and hybrid funds as well to reduce risk. Debt mutual funds being safer than equity mutual funds became the conventional wisdom - in part because portfolio advisors and others hammered home that message repeatedly.
The risk in the debt mutual funds varied of course - with gilts being the safest and liquid funds being perhaps the riskiest, according to many experts. But most advisors insisted that debt as a class was safer than equity. After all, India did not have a culture of investing in junk-grade debt for higher returns.
The problem was that the conventional wisdom stood on a fairly unsteady pedestal. The first big jolt to debt mutual funds came when Amtek Auto defaulted on its payments. But that was treated as a one-off and most debt fund managers shrugged it off.
Since last year though, the fact that debt mutual funds are fairly risky has become increasingly apparent. Debt mutual fund managers were often investing in commercial paper of NBFCs as well as other companies in order to give higher returns. They did take all precautions - investing largely in highly rated papers, most often those that had been rated triple AAA or similar by the credit rating agencies. Except that like retail investors who lost money in commercial fixed deposits in the 80s and 90s, they should have realised that highly rated paper is no guarantee that the money was actually safe.
In the past year, a number of defaults and rescheduling of debt commitments - by IL&FS, Zee, Dewan Housing and Reliance Capital among others - have shown how wrong the assumption was. Several Fixed Maturity Plans had to delay their payouts because of problems in companies whose debt they had subscribed to. Others saw their NAVs erode overnight once news of a default or a debt payment rescheduling came to light.
It is increasingly becoming clear that the idea of debt being safer than equity was illusory at best. Yes, debt as a class had some benefits - secured debt would most likely be repaid first if a company had to be liquidated. But other than that, debt offers no more safety than equity does. Perhaps a bit less in fact because equities have to undergo far greater scrutiny and markets react to news in the equity market a bit more quickly than in the debt markets.
This in turn means the conventional theory of diversifying portfolio risk by holding a portion of the assets in debt funds is meaningless. It is time that investors woke up to this.
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