FUND FLAVOUR

December 2013

 

Debt Funds dominate…

Contrary to popular perception, mutual funds are primarily debt investors. For retail investors, investment in mutual funds has always been a substitute for direct investment in equity markets. This preference has created a distorted notion that mutual funds are predominantly equity investors. An analysis of the market data, however, paints a picture that is surprising as well as revealing. As on June 30, 2013, the total AUM of mutual funds stood at Rs 800688.22 crore. Out of this, debt assets alone aggregated to Rs 620094.90 crore – a 71% share of the total AUM. This reflects the overwhelming preference of mutual funds for debt instruments. The total mutual fund AUM invested in debt as on March 31, 2009 was approximately Rs 2 lakh crore – a 49% share of the total AUM. Since then, the mutual fund debt assets have grown at a compounded annual growth rate (CAGR) of 30% as against a CAGR of 18% for the total mutual fund AUM (that includes debt, equity, alternate assets, etc). The preference for debt investments can be attributed to lucrative returns offered consistently by this asset class over the past five years. According to CRISIL – AMFI Debt Fund Performance Index, an index that seeks to track the performance of 86 debt funds, debt funds have offered consistent returns of 8.93% over the last 5 years, 8.78% over the last 3 years, and 11.11% over the last year (as on June 30, 2013). In contrast, equity markets have been too unpredictable over the same period. Consequently, mutual funds have been net sellers in equity and net buyers in debt, over the stock exchange, over the last four years.

Source of funds and investor preference

As on March 31, 2013, the fund contribution of corporate and high networth individuals (HNIs) to mutual fund debt funds (liquid funds, gilt funds, and debt oriented funds) stood at 60% and 30% respectively. The remaining 10% was contributed by banks, financial institutions (FI), foreign institutional investors (FIIs), and retail investors (individual investors with investments of less than 5 lakh). Further, analysis of the AUM data indicates that 92% of funds in debt schemes are from corporate investors, 89% of funds from Banks/ FIs, 77.5% of funds from HNIs, 43% of funds from FIIs, and 18% of funds from retail investors. While corporate, HNIs, FIIs, and retail investors preferred investing in debt oriented funds, HNIs, Banks, and FIs primarily invested in liquid funds.

 

Allocation across schemes and distribution across maturities

In terms of number of debt schemes, 749 out of 1184 schemes were income/ debt oriented schemes. This preponderance was despite the fact that equity mutual funds have a favourable tax treatment as compared to debt mutual funds. Within the debt schemes, almost 72% assets (Rs 441310.11 crore) were under regular debt schemes, 26.5% assets (Rs 170862.68 crore) were within liquid/ money market schemes, and remaining 1.5% assets (Rs 8473.19 crore) were under gilt schemes. A significant chunk, 45.20% of all debt assets, is invested in instruments that have a maturity of 90 days or less. Overall, 67.5% of all debt assets are invested in instruments with maturity of less than one year. Though mutual funds seem to be reluctant investors in maturities above one year, there has been a marked shift towards longer maturity papers.

Choice of debt instrument

The choice of instruments also corroborates with the preference for liquidity and safety. Over 50% of all assets are invested in extremely liquid short term papers viz Certificates of Deposit (31%), Commercial Paper (15%), Bank FD (6.64%), CBLO (3%), other Money Market Instruments (3%), and Treasury Bills (0.03%). This inclination for safer liquid assets is also reflected in higher portfolio allocation to better rated Corporate Bonds (23.45%), and PSU Bonds (8.20%). It should be noted that higher rated (AAA, AA+) corporate bonds are relatively more liquid than other bonds.

A brief account of the performance of the major categories of debt funds, namely, gilt funds, FMPs, and liquid funds, would put things in the proper perspective.

Gilt Funds

Gilt Funds are mutual fund schemes that invest in government securities (G-Secs), issued by the RBI on behalf of the government. Being sovereign papers, these do not expose investors to credit risk. The G-Sec market is largely dominated by institutional investors and gilt funds are an avenue for retail investors to participate in the market. These are ideal for those who want more safety for their investments or are risk-averse and, at the same time, are looking for reasonable returns on their money. These are a good option when inflation is near its peak and the RBI is not likely to raise interest rates immediately. On the flip side, factors such as fiscal deficit and the country’s debt burden weigh on the performance of G-Secs and hence, gilt funds. Investment in gilt funds is subject to interest rate risks. These funds invest in G-Secs, which are not actively traded and are hence highly illiquid. According to mutual fund rating agency, Value Research, medium and long-term gilt funds gave returns of 3.84% for the year ended May 30, 2013. In the short-term (less than a year), they have returned 4.18%. But efforts by the RBI in July 2013 to salvage the rupee have hit these funds hard. A meaningful portion of the gains made by gilt funds in the last one year were eroded by this move. Even as many market participants believed this to be a one-off event, the volatility does not seem to be reducing. The benchmark 10-year G-sec yield has risen by nearly 100 basis points in the last one month and bond prices slid by as much as 6%. As a result, gilt funds, on an average, lost over 3% in a short span of ten days, which is a rather short period of time to gauge the performance of a fund. However, episodes such as this occur rarely but they highlight that the fund manager’s ability to manage rate risk is important to reduce volatility in returns.

 

Fixed Maturity Plans

FMPs invest in a mix of short-term options, such as money market instruments, certificates of deposit, commercial papers, and the like. Given that these are currently offering a yield of 9.5-10%, the funds are also likely to deliver a similar pre-tax return. The investors who lock in money at the current level should enjoy double-digit returns over a one-year horizon. The recent RBI move to tighten liquidity has put a big question mark on the trajectory of rates. The uncertainty regarding the future interest rate movements makes FMPs a safer bet. FMPs offer returns that are relatively predictable, though not guaranteed. These are closed-ended, or of a fixed tenure, where the fund invests in instruments with a maturity profile matching that of the fund, and the instruments are typically held till maturity. For instance, a one-year FMP will invest in fixed income instruments bearing the same maturity. As such, any gyration in interest rates in the interim period does not affect the value of the fund. Hence, in an environment where the stability of the debt market is suspect, an FMP provides a safer way to navigate the uncertainty. This is a good window for investors to lock in their money at higher yields through FMPs. They should supplement the riskier open-ended funds in their portfolios with more stable FMPs. Besides, FMPs are more tax-efficient. Opt for a fund whose tenure matches your investment term and financial goal. If you are risk-averse, go for a higher tenure product, which will enable you to lock in at high yields for a long period. If you plan to buy a car after a year, a one-year FMP will be ideal to help make the down payment. It is critical to choose the tenure wisely since these funds have a lock-in period and you will not have access to your money for this duration. Even though these instruments are listed on the exchanges and are tradeable, the liquidity is very low. So you cannot sell whenever you want without having to compromise on price. Opt for fund houses that typically invest in the highest quality instruments, such as AAA or AA rated corporate or PSU bonds. There is a high risk of default in the underlying paper if it has a lower rating.

 

Liquid Funds

Liquid funds are getting increasingly popular these days because of the high interest rates, safety, and tax advantage that they offer. A recent study conducted by CRISIL Fund Services has pronounced liquid funds, an attractive alternative to retail investors for parking funds lying idle in their savings bank accounts. Over the last five years, liquid funds (Crisil Fund Rank 1 index for liquid funds) have given an annualised post-tax return of 5.78% as compared to 2.5% given by a savings bank account. Despite this disparity in returns, a majority of Indians continue to park a large amount of funds in savings bank accounts. Beyond returns, liquid funds also have advantages in terms of liquidity, safety and portability. They can be redeemed within 24 hours and have no exit load. Further, liquid funds invest in securities with a maximum maturity of 91 days, which cuts down the credit risk. Most liquid fund schemes are also highly rated (P1+f), signifying very strong protection against losses from credit defaults. Within liquid funds the dividend option is more tax-efficient. This option would be more suitable for investors who fall within the 20 and 30% tax brackets, as it attracts a lower dividend distribution tax of 12.5%. Post tax deductions, liquid funds yield better returns as compared to savings accounts and fixed deposits, wherein the interest earned would be taxed based on an individual's tax slab.

…retail investors yet to join the league

A debt fund has a lot going for it as an investment. In fact, it is the only way to invest in income-generating instruments without having to commit huge sums of money or getting entangled in assorted worries such as transaction costs, stamp duty, or lack of liquidity. In fact, many of the most attractive debt instruments are unavailable directly to the retail investor. Debt fund is an ideal investment if you want to meet short-term goals, park emergency reserves profitably, pay less tax than FDs, generate regular income, and use it as a launching pad for large equity investments. Despite their advantages common investors mostly ignore debt funds. By this logic, debt funds should get a unique place in your asset portfolio.