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.
