Debt Funds or Not

An old colleague called me today to discuss which mutual fund I would recommend her to invest in. As always, my recommendation was to invest in index funds, to invest directly, and to invest over a period rather than at a point in time. She said that she has a guy who handles her investments and he is recommending that she should invest 50% amount into debt funds. Luckily, she said no to her guy about the debt funds but wanted my opinion on whether she made the right choice. Under the circumstances, I believe, she made the right choice. I, too, would stay away from debt funds, at least, until the economy recovers, and we have clarity over where corporate earnings are headed. But I wanted to write a quick post to discuss the debt funds and why they are popular suddenly.

What is a Debt Mutual Fund?

Debt mutual fund is a category of funds which invests majority of its money into fixed-income securities such as government bonds, debentures, corporate bonds, etc. Each of these securities carry a different interest rates depending on the risk involved. It is worth noting that a government bond would offer the lowest interest rate because the risk of government bond failing is extremely low, and a corporate bond offer higher rate of return because they carry a risk of failure. To further understand debt funds, we need to understand corporate bonds better.

What are underlying Corporate Bonds?

Bond is a fancy word to say loan. When a company borrow money from a bank, the company calls the borrowing a loan and list it under liabilities on its balance sheet. When a company borrows from public, it's called issuing bonds, and that the public has bought bonds. Just like interest on bank loans, the company would pay interest on its bonds, and both have a fixed maturity too.

There are many reasons why a company chooses to issue bonds rather than take a bank loan. The número uno being that they are cheaper than bank loans. E.g. my bank is offering me a loan at 12.49% interest. That’s low for a no security personal loan. The same bank is willing to pay me 5.7% interest on fixed deposits. That a wide 'spread' for the bank. Granted that the interest is lower on other kind of loans such as home loans, car loans, education loans, etc., which are secured with some collateral. Still, 12.49% is the lowest I have heard.

With an issue of bonds, the company is doing nothing but borrowing money from public rather than a bank. If the company offers 9% interest on its bonds, then it's a win-win for both the company and the public. However, I believe the reason to issue bonds is also because it is complicated to borrow money from a bank. If I approach a bank to borrow $100 million, I may have to provide a collateral, a guarantor, provide access to confidential business information, provide a lien on future earnings, appoint a bank officer on the board, etc. I am not saying that in case of issuing bonds, the company is not providing all that information. But the $100 million risk in case of bonds is spread over a considerable number of individuals, each one of them may not have the resources to scrutinise company's financials like a bank would.

In fact, most of the bond offers are backed by assets but that's debatable. Many a times corporates issue bonds through a complex chain of entities. Suppose an airline "ABC Skies" wants to add 3 new aircrafts in its fleet. It may choose to issue bonds and purchase new aircrafts. Alternatively, "ABC Skies" could form a separate entity called "ABC Financial Services" to issue bonds and raise the money. Then this money would be loaned to separate entity called "ABC Air Fleet," which would purchase the aircrafts and lease them to the airline "ABC Skies." The bonds are secured by the loans to "ABC Air Fleet." The loan to "ABC Air Fleet" are secured by the aircrafts as collaterals. In case the business of "ABC Skies" is down, the airline can terminate its leasing contract with "ABC Air Fleet." In turn, "ABC Air Fleet" would default on its loan and offer the depreciated collateral to "ABC Financial Services." Eventually, the bond holders will end up bearing the burden of liquidation and default. Of course, this may not always be the case. But it is also the case, more often.

The above arrangement is perfectly legal and highly recommended to limit liabilities and to protect the business of an ongoing concern i.e. the airline. We also notice that while the bonds were secured by 100% assets, in case of a default the bond holders end up bearing the shortfall and expenses related to liquidation of the underlying assets. Even if a company does not choose to form such complex chain of companies, the bonds are only going to be secured up to the initial principle amount which may not be sufficient in case of a default.

Why are debt funds becoming popular recently?

There are several reasons. First, the NAV of a debt fund looks like this:

Suppose the above fund is invested in a 12-year corporate bond which offers 9% interest compounded annually. Every year the fund will have accrued interest that would be reflected in the NAV of the fund. However, mind you that the bond has not really paid anything till date to its investors. Nevertheless, a graph like the one above puts investors at ease by painting a picture that promises steady returns and minimal risk.

Second, these bonds are being marketed more aggressively than ever. Since, issuing bonds means raising money from many small investors, the issuing company hire underwriters, which, for a significant fee and commission, processes the bond sales. The underwriters also approach mutual funds to invest the fund they have raised from investors into these bonds. Furthermore, financial advisors (like the guy that my colleague has) are offered commissions and incentives to promote the debt funds or corporate bonds. It is simple human nature to promote products which offers us most commission and earnings.

What's my reservation about corporate bonds?

Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't... pays it. ~Albert Einstein

I'll summarise my concerns below:

1. Compound interest adds up. Bonds are issued for a long duration - 5, 10, or 15 years. A company promising to pay principal and accumulated interest at the time of maturity is promising a lot.

2. Cost of commissions and incentives adds further burden on the company. Suppose the company issues bonds worth $100 million at 9% interest for 10 years, paid 5% commission to underwriters and incurred $2 million in administrative costs. Then it effectively raised $93 million. However, it will have to pay interest on $100 million.

3. Lack of resources with individual investor to understand whether the bonds are secured by an underlying asset. Whether the asset is good to cover 100% of amount payable, after depreciation, at the time of redemption?

4. The complex chain of companies is a bitter reality

So, should I stay away debt funds/corporate bonds completely?

Of course not! We just need to be diligent. Let's start with two thumb rules:

1. If it is too good to be true, it is. E.g. an offer which promises wonderful things such as high interest rate, unusually high profits, super-aggressive growth plans, etc.

2. Look for the reasons to how the money raised through bond sales will be used. Whether the money is going to be used to pay for existing debt, clear of outstanding liabilities, or to make investments in future growth plans. A company investing in growth will stand a better chance to meet its redemption commitments.

Additionally, let's keep the following in mind:

1. If you can choose, choose the option to receive interest payments periodically, rather than accumulate. I know you miss compounding interest, but interest payments in hand gives you an option to invest further and spread your risk.

2. Any form of investment, whether bonds, shares, bank deposits, etc. should constitute a portion of your portfolio.

Lastly, invest directly and invest over a period, rather than at one time.

May 2020 Update: I recently learnt of a bond issue by Future Retails. Read my analysis of the bond issue here.