FUND FLAVOUR

November 2015

When planning to invest in mutual funds, whether equity or debt, there are two questions you must ask yourself:

·         What is my risk appetite?

·         What is my investment horizon?

The reason being these two questions determine your investment avenue. So if you are a risk-taker with a long-term horizon (at least 5 years) you can park your money in equity funds. Conversely, for risk-averse investors with 3-5 years’ investment horizon, debt funds are a safer and better option. Debt funds are mutual funds that invest in debt and fixed-income securities, such as corporate bonds, debentures, government securities, and commercial papers. These securities guarantee safety of principal and income. However, these two features come at a cost — returns are much lower than that of equities in the long run. Therefore, debt funds suit you if you prefer certainty of income with low or moderate level of risk.

Debt funds vis-à-vis Bank Fixed Deposits

But safe investors will say why not invest in bank fixed deposits instead of debt mutual funds? Well, here is why you should not:

1.      Gains from falling interest rates: The 50-basis point repo rate cut by the RBI recently has led to the lowering of FD rates. Many banks have cut their deposit rates by 25 basis points. So, if you have been parking your investments in bank deposits, your returns from future deposits will take a beating. But, guess what — even falling interests could help you earn more! Unlike bank deposits, debt funds allow you to gain from falling interest rates as bonds prices have an inverse relationship with interest rates.

2.   Better liquidity: Bank deposits are not tradable and if you wish to withdraw money, you cannot close the fixed deposit in part. Banks charge penalties for premature withdrawal. However, debt funds are more liquid as you can withdraw any amount from your total fund value.

3.      Low taxation: Debt funds attract almost nil taxes after 3 years while interest earned from bank deposits is taxable. Moreover, the interest earned from bank fixed deposits will be taxed under your maximum tax slab while a debt fund redeemed after 3 years would attract long-term capital gains (LTCG) tax of 20% flat rate with indexation. Thus, if you fall under higher tax bracket, you stand to gain from investing in debt funds even if the rate of returns from debt funds and fixed deposits are the same.

Points to ponder

However, there are some aspects that buyers must keep in mind while investing in a debt fund. There are attractive opportunities in debt schemes for retail investors, starting from overnight investment in liquid funds to duration debt products like, gilt funds, income fund, and dynamic bond funds. Liquid debt funds are ideal for those with an investment horizon of less than a month and ideally should be used to park money instead of a savings bank account. Ultra-short term fund investments are for less than 90 days and can be compared with short-term fixed deposits. Short-term debts funds are ideal for those with an investment horizon of 12 months. The tenure of the debt fund is very important because due to the longer period, there is additional risk and higher exposure to interest rate fluctuation. As the value of bonds is inversely proportional to the interest rate, a rise in the interest rate will see a fall in the price of bonds and vice-versa. So, a bond with shorter duration has less chance of fluctuation in the interest rate as compared with long term bonds. Investors must focus on the risk appetite and return expectation to decide on the right tenure of debt fund.

The economy paints a rosy picture…

Apart from these parameters, the prevailing economic conditions may also influence your decision to invest in debt funds. Let us review some of the factors that may affect the performance of debt funds in short- to medium-term horizon.

         Falling interest rate regime: The Reserve Bank of India (RBI) has already cut the repo rates by 125 basis points in 2015.  The latest 50 basis points rate cut by the RBI on September 29, 2015 has led to hike in bond prices in India. During a falling interest rate regime, debt funds with longer investment horizon, such as dynamic bond funds, gilt funds, and income funds, would gain the most when compared to short-term debt funds.

         Falling global commodity and fuel prices: The falling global commodity and fuel prices would ease inflationary pressures in India which would, in turn, give RBI more room to further bring down interest rates. As bonds prices and interest rates have an inverse relationship, falling interest rates would further increase bond prices, thereby, pushing up the value of your investments in debt mutual funds.

         Volatility in global markets: In a globalized world, Indian markets cannot stay totally immune to adverse events in peer markets. The present volatility in global markets, coupled with slowdown in China, has adversely affected the FII inflows into India. An expected Federal Reserve rate hike may further lead to flight of capital from emerging markets, including India. As the reduced FII inflows may hurt returns from your equity funds, you can invest in debt funds if your risk appetite is limited.

To sum it up, in the current economic scenario, if you are a risk-averse investor looking for assured returns, debt mutual funds would provide higher returns compared to other fixed income options like bank fixed deposits.

…but are debt funds lagging their benchmarks?  

For actively managed mutual funds, the return generated in excess of the chosen benchmark is what determines the worth of the fund. While this is particularly true in the case of equity funds, debt funds are not subjected to this scrutiny for various reasons. But a close inspection of fund performance relative to benchmark brings out a sharp contrast in the two categories' performance in recent times. While equity funds' relative performance has been strong, debt funds have not fared well on this count. Over the past one year, for instance, 49% of debt funds have underperformed their respective benchmarks. For the same period, just 17% of diversified equity funds failed to beat their benchmark. Over three years, 57% of debt funds have been beaten by their benchmark whereas only 11% of equity funds met the same fate. While debt funds by nature cannot outperform their benchmarks to the same extent as equity funds, the degree of underperformance in the former does raise some questions. Lack of liquidity in the debt market is the primary reason for debt funds' underperformance. The underperformance is visible across short-term and long-term debt funds. However, short-term debt funds cannot outperform much. They are highly susceptible to redemption pressures arising out of liquidity needs. A slight underperformance in debt funds should not be a concern. Unlike equity funds, relative performance is not really much of a criterion in the selection of debt funds. A good debt should provide the right balance between safety of capital and reasonable return.

Selection strategy

Debt funds are considered to be the safe investment, but if not selected properly in line with the suitability, they can be as risky as equity funds. Some of the checks one can make before selecting among debt funds are as follows:

1.     Average Maturity: You should be clear about your goal and time horizon. Your time horizon should match with the average maturity of that fund. Average maturity tells the weighted average maturities of all securities held in that fund. So if you want to park your money for 1 month then you should not go with Income funds or Gilt funds having higher average maturity. The best selection for you would be liquid or ultra-liquid Funds.

2.     Modified duration: Modified duration is the measure of sensitivity of particular fund to market interest rates. Like Beta is for equity funds, Modified duration is for debt funds. Higher the modified duration, higher will be the volatility. Thus if you expect market interest to go down in near future than you should go with the funds of higher Modified duration. But be informed it also carries equal risk, which means that if your expectation does not turn up correct then your assumed gains can be converted into losses.

 3.     Yield to maturity (YTM): This figure will give you an idea of what returns can you expect out of fund’s portfolio. This figure must be compared with current returns of your safe instruments like PPF/Bank Fixed deposits. Yield of funds should not be much higher in comparison. Higher yields sometimes would mean compromising on the quality of papers and thus safety of instruments. This increases credit risk in those bonds and sometimes leads to liquidity risk also.

 4.     Quality of papers in portfolio: The quality of debt instruments in the fund’s portfolio is of utmost importance and should be scrutinised closely. One should check the credit rating assigned to each instrument like AAA, AA+ etc. This signifies the level of credit/default risk. The higher the rating, the safer the instrument. While a debt fund with a risky paper is likely to yield higher returns, it may work unfavourably for the investor. As to a debt investor the safety of capital is very important, so one should avoid the funds with low quality investments.

5.     Expenses ratio: The expense ratio is very critical for a debt fund as the returns are low. Return expectation out of debt fund is in the range of 8-10%, thus expensive cost structure will have a negative effect on the returns. So it is very important for investors to ensure that the cost structure is low and in line with the returns being offered by the fund.

Match holding period with the specific strategy you choose

The recent downgrade of a bond held by two schemes of a major fund house has brought risks involved in debt mutual funds back into the limelight. The episode has shifted the focus on how fixed income mutual funds work and how they should be used in a portfolio. It is believed that robust portfolio construction (how you allocate your money across different debt mutual funds categories) is the most crucial element to be put in place before buying debt mutual funds or reviewing the funds that you have in your portfolio. A well balanced debt mutual fund portfolio needs to have different elements combined together to deliver superior risk adjusted returns. Combine different strategies: Debt mutual funds serve different purposes — liquid and ultra-short-term funds are for parking temporary surpluses, and tend to outperform savings/current accounts in banks where short-term surpluses are typically kept. Dynamic bond funds have the flexibility to decide how the fund manager wishes to allocate the money across the mentioned strategies. In addition, there are also fixed maturity plans (FMPs) which hold bonds to maturity to try to lock into a certain rate of interest. A clear understanding of each of these strategies is critical, and to combine them together to create a well-diversified portfolio is imperative. Always keep time horizon in mind: Each of the above strategies is suited for a certain holding period and it is therefore critical to match the period with the strategy. A mismatch in holding period expectations and portfolio construction could cause a significant challenge. Factors like modified duration and average maturities of the portfolio, exit load structures and composition of underlying securities must be monitored.