FUND FLAVOUR

December 2016

As a community, investors have traditionally harboured misguided notions about debt mutual funds. Some consider them to be fixed interest bearing securities, whereas others understand gilt funds to be low risk, as they invest in sovereign bonds. Although it is true that debt funds are less volatile and have a lower risk than equity funds, it is vital for mutual fund investors to have a basic understanding of how they work, and especially the risks involved. With interest rates in traditional instruments falling in line with declining interest rates (PPF rates have been dropped to 8.1%, SCSS to 8.6%, and PPF to 8.1%), risk-averse investors need to necessarily consider debt mutual funds in order to continue beating inflation while avoiding risks.

An integral part of the portfolio

Debt funds should form an integral part of any investment portfolio for two major reasons: One for stable returns, and two, to spread across risks so that there is a cushion when rates fall and equities tank. In addition to equities, prudent fund managers often shuffle portfolios across varying maturities in debt, depending upon market conditions. Today, in the Indian context, interest rates are seen downward in the longer time frame, though near-term could be steady to firmer. There are, however, inherent risks involved if two facts – volatility and time frame – are not taken into consideration.

Volatility: It is a factor that leads to a sharp rise or fall in the prices of debt instruments when interest rates dip or rise respectively. Interest rates and bond prices are inversely proportional, meaning if interest rates drop, bond prices soar, and the reverse occurs when interest rates rise.

Time frame: It is the period for which funds are parked or invested. One can even invest in debt for a period ranging between a day and as long as 30 years. Broadly speaking, investment options in debt can be divided into short, medium or accrual, and long-term debt funds.

Short-term funds: These are liquid funds where one can earn returns of 200-250 basis points above the savings bank rates of 4-6%. Liquid funds, as the name suggests, are as good as any saving account, the only difference being one would perhaps need a day or two for the funds to come into the kitty. It has been often observed that many savers let funds idle in bank savings as a protection for future eventuality or emergency, little knowing that liquid funds offer the same benefit and even earn a higher rate than savings. The instruments in which such funds invest are short-term government papers like treasury bills and other money market instruments of shorter maturities of three months or less. There are cases where smart investors park their salaries in such instruments till their regular outflows like SIPs, home loan installments, insurance premiums, etc., begin. For example, if your home loan EMIs are slated for the tenth of every month and the salary is credited to the account on the first of every month, by parking the same funds in liquid funds, you stand to enhance your interest accruals by at least 200 basis points for that nine-day period instead of the 4-6% earned in a savings account.

Medium term/accrual schemes: These schemes typically invest in government bonds and corporate bonds while maintaining the average maturity of around 3-5 years. The corporate bonds in this case need not necessarily be AAA rated bonds, but a notch or two lower as they offer higher returns to the fund. The view of the investor, on the other hand, is one of a shorter duration. Three years or more is recommended for tax exemptions and typically syncs with the investors' need for future requirements. The reason why fund managers recommend investments with a duration of three years and above is that the returns are as good as tax-free. Such funds are also called accrual funds. These funds maintain a higher yield to maturity (YTM) through exposure to sub-AAA assets while AAA assets of 5-10 year maturity are taken as a hedge to provide the benefit of price appreciation should interest rates fall. Higher the accruals, lower will the corporate bond maturities be, and therefore, lower the interest rate risk. For example, if the interest rate view of a fund manager is that of a softening trend, in such a case, besides earning the interest rates or coupon on the bonds, the portfolio would appreciate if the view holds good. However, if the view held turns wrong, which is, the rates firm up, prices of underlying securities begin to slide. This is when fund managers recommend systematic transfers to average out the costs of the underlying.

Long-term investments: The longer the duration, the more will be the volatility in the near-term, but returns get adjusted with time if rates are stable or easing. In such a case, the key driver of returns is the fluctuation in interest rates. Given that macroeconomic fundamentals and long-term interest rates are poised downward, long-term investors stand to gain from price appreciation of the underlying securities. However, there could be intermittent blips where the returns could be lower.

To get debt funds’ mix right…

Though debt funds are relatively less risky than equity funds, interest rate movement can create volatility in short term. While equity funds have the ability to generate blockbuster returns in bullish times but may turn volatile in bearish markets, debt funds can help generate relatively more stable steady returns in good and bad times given that underlying portfolio in a debt funds consists of instruments which have generated some yield at all times. The terminology and names used to define different types of debt funds can be confusing to a layman. This might even lead to investors shunning debt funds. For any investor, therefore, it is important to get the mix right.

…solve the jigsaw puzzle

Getting the mix right is a bit like a jigsaw puzzle. Once you have the pieces come together, the full picture emerges and this gives clarity on how the portfolio is shaping up. The four pieces in this jigsaw when it comes to debt funds is investment horizon, risk appetite, level of diversification (scheme and AMC level), and return expectation.

Investment horizon

Typically an investor should break up his investible surplus into that which could likely be redeemed within one year (short-term) and those which can be kept for longer tenors (more than 1 year). Those investments which are meant for short term should be invested in debt funds which ideally do not have exit load and have low maturity and hence would be subject to low short-term volatility (due to movement in interest rates). Two typical types of debt schemes which fall in this category are liquid funds and ultra-short term schemes. Investors should also keep in mind the tax applicability so as not to be hit adversely by short-term capital gains in the event of exit less than three years in debt funds. Hence taxation would also be a key determinant of investment horizon. Here a comparison between liquid/ultra-short term debt funds and arbitrage funds (equity) would be worthwhile as arbitrage funds enjoy favourable tax treatment. Tax treatments for various types of mutual funds do undergo changes during the presentation of Union Budget, so one should be updated about investments done post Budget especially in the new financial year before making fresh allocations.

Risk appetite

Although debt funds are relatively less risky than equity funds, however, interest rate movements can create volatility in the short end. We call this interest rate risk. This risk is measured typically a measure called modified duration. Every debt scheme portfolio would have a modified duration which is a weighted average of the modified duration of individual debt instruments in its portfolio. Schemes with higher modified duration can generate high returns in bullish times (when interest rates head lower and prices rise) but also give low returns in bearish times. Also, different types of debt instruments carry different yield based on credit of the issuer. For example, a 10-year sovereign government bond would today yield 7.75% annualised yield. A 3-year AA rated NBFC bond could yield 9%. We call this credit risk. So credit funds or high-yield debt funds which invest in relatively lower rated papers carry higher credit risk but can also generate higher returns. While individual debt instruments also have varying levels of liquidity risk, for the investor this should not be much of a concern as mutual fund open-ended debt schemes typically offer daily liquidity. So investor can redeem money any day. The only exception to this rule is FMPs (Fixed Maturity Plans) or capital protection oriented schemes or other hybrid debt-oriented close-ended schemes. There should be therefore a balanced allocation to short-term and long-term debt funds and credit or high yield/accrual bond funds depending on one’s risk appetite.

Level of diversification

How many debt schemes and how many AMCs does one need to have in one’s portfolio? Not too little and not too much! There is no one golden number or rule. It depends entirely on each individual investor and how well you can manage and juggle your investments.

Return expectation

It is important to have expectations of realistic returns and be ready for disappointments. It is quite possible that even after figuring out the above three factors, some debt schemes at some point in time could underperform or disappoint you in terms of returns being offered. A practical approach would be to take a decision on whether to continue to investment or redeem and put the money to work elsewhere. For this you need to differentiate on whether the underperformance is due to fund manager level issues or market-related issues. If the former, one may need to switch the AMC and if the latter, one need to move into a different type of debt scheme or wait out. If the above is bogging you down, think of taking help of a distributor or adviser. Advisers who work on a fee basis and invest your funds in direct plans rather than those who do not take a fee but invest your funds in regular plans would be a better option. Also active monitoring of your investments on a periodic basis is a must to take a mid-course correction if required.

If you manage to put the pieces of the jigsaw puzzle together, it would ensure your money is put to work really hard and you are on course to meet your investment and saving targets.

Debt fund performance with promises of a better future

If you have any financial goal(s) which is less than five years away, which can be met with 8% to 10% rate of return or when you are not comfortable with high volatility (risk) then you can definitely consider investing in debt mutual funds. The returns from debt funds are mainly dependent on the interest rate scenario prevailing in the economy. Some of the debt mutual funds, especially dynamic bond funds, gilt funds, and long-term debt funds have given better returns than bank fixed deposits over the last one to two year period in view of the downward trend in interest rates. The average liquid fund category returns in the last three months and one year are 1.5% and 6.8% respectively. The ultra short-term debt funds, also known as liquid plus funds or cash/treasury management funds, as a category, have generated 2% and 7.9% in the last three months and one year respectively. Short-term funds, also known as short term credit opportunities fund, have returned 8.8% and 7.9% over the past one and three years respectively. The average returns generated by the funds which are in the dynamic and long-term income bond funds category are 9.2% and 8.8% during the last one and three years respectively. The average category returns of gilt funds for the last one, three, and five years are 10.08%, 9.4%, and 7.8% respectively.

Changing investment pattern: Debt funds to rule the future

The Indian mutual fund industry is almost Rs 16 lakh crore strong with fixed income or debt having a two-third share at about Rs 10 lakh crore, the rest being largely equity. The share of debt funds has not changed much from a decade ago when the industry size was less than Rs 2 lakh crore. Another characteristic which has not changed is the institutional dominance (mainly corporates and banks) of the category despite having grown by about 7 times since 2005. However, tax arbitrage and lower expenses for institutional plans now being history, the ratio is bound to shift towards retail investors over the next 5-10 years. But we still have a long way to go as RBI data indicates that about Rs 90 lakh crore is parked in bank deposits, 10 times the money in debt mutual funds and over 35 times the retail debt AUM. This is mainly due to lack of awareness about the benefits offered by debt funds besides the ‘assured returns’ psyche of retail investors. This is bound to change as overall interest rates are likely to fall as India grows. In fact, many investors already shop for higher interest rates by moving from nationalised to cooperative banks. Two factors stand out in favour of debt mutual funds — variety and convenience. In terms of variety, debt funds are available across horizons and risk appetites. Accordingly they can be broadly classified into short term and long term debt funds. For short term investment horizons one may choose between liquid funds (3-6 months), ultra short term debt funds (less than one year) and short term debt funds (less than 3 years). One may choose income and gilt funds if investment horizon is more than 3 years. On the basis of risk, one needs to look at interest rate risk and credit risk. The former is due to change in rates in the economy. This risk can be gauged by average tenure of portfolio holdings — longer the tenure, higher the interest rate risk. Accordingly, liquid funds carry the least interest rate risk while gilt funds carry the highest interest rate risk. In terms of credit risk (risk of default or delay in payment of interest and principal), gilt funds carry nil credit risk as they hold sovereign bonds. So why not invest in only sovereign bonds. Higher yields do matter to investors whether it is FDs or debt funds. Government bonds fetch yields of 7.44-7.77% over 1-10 year bonds. One therefore needs to invest in corporate bonds to beat these yields. But AAA bonds only offer about 0.45% more for 10-year bonds while this is about 2% if is an A+ rated bond. This clearly shows the inverse relation between credit rating and yields as highest rated companies borrow at lowest cost. Mutual funds thus invest in AAA, AA and A rated bonds, all of which are within investment grade rating of BBB(-). Last but not the least is convenience. Most mutual funds are highly liquid. One can even start a monthly systematic investment plan or SIP for as low as Rs.500 per month. The most pertinent question then is how to choose the right funds. The easier way out is to consult your professional financial advisor. Once you have zeroed on the debt fund category, narrow your choice by looking for a pedigreed fund house and fund management team besides looking at its vintage. If they have been around for 1 or 2 decades, it surely gives a lot of confidence having seen multiple market cycles.