Debt Funds

Recently, the unheralded and largely unnoticed demise of a once-promising mutual fund made think about debt fund investing and the true nature of diversification in debt funds. This fund was the Franklin India International fund and had a negligible asset base when Franklin Templeton put it out of its misery last week. However, this was one of India's first international funds and when it was launched, it was an interesting innovation in debt investing.

The fund was entirely a feeder fund for a US-based fund run by the fund company's US-based parent. That fund, in turn, is dedicated to investing in US government debt. When this fund was launched eight years ago, I thought that it was one way diversifying one's debt exposure. However, in the years that followed, a variety of upheavals ensured that US treasuries were never an interesting enough option when compared to Indian debt.

Also, during the intervening years, debt investing has evolved greatly in India. The basic fact remains that debt returns are enormously higher in India than in the developed markets. Long-term yields in India have rarely fallen below 6 per cent on a sustained basis and even safe short-term debt easily yields 5 per cent or so. Geographical diversification on debt seems to have two options-the stagnating economies of the west which have tiny yields; and higher-yield regions which are too unfamiliar and carry unpredictable currency risk. In fact, savvy long-term debt investors periodically get opportunities to lock-in double digit yields on high quality debt, something which is now unimaginable in the developed economies.

Moreover, both the Indian debt investor and the Indian fund industry has become far more sophisticated about debt funds. Investors understand and exploit the basic yield and maturity slope very well (if perhaps a little too actively). Fund companies, on their part have done a great job of creating a liquid market for debt funds out of what is basically an illiquid market for much of the underlying debt. The process has been remarkably smooth, apart from the hiccup in October 2008 that was really an inevitable fallout of the global liquidity crunch.

If there are any elements that are missing from this picture so far, then they are products that exploit lower-rated debt to get higher returns, and debt products that are meaningful for retail customers. Periodically, there have been funds that have tried to exploit former niche, only to be stymied by a disinterest from investors. Once again, recently, there are a number of 'credit opportunities' funds that are taking shape to fill this space.

As far as retail debt goes, I'm sure it will continue to be a fringe activity. There is such a plethora of government-guaranteed deposits available at decent returns, that no small investors ever looks at debt funds. And in terms of popularity, even these instruments are a distant second to the trusty old bank deposit that looks like forever continuing its hold on Indian savers.