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Debt Mutual Fund Investing In The Current Scenario

In order to effectively invest in debt funds, an investor needs to have a basic understanding of where interest rates might be headed over the coming months

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As a community, investors have traditionally harbored 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's true that debt funds are less volatile and have a lower risk than equity funds, it's 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 per cent, SCSS to 8.6 per cent and PPF to 8.1 per cent), risk averse investors need to necessarily consider debt mutual funds in order to continue beating inflation while avoiding risks.

How debt funds work
A debt fund manager may follow two strategies in order to generate returns. The first is "Accrual", wherein the aim is to hold a portfolio of relatively short term corporate or government bonds, with the aim of "accruing" the interest from these bonds once they mature. The main risk in such an approach would arise from the lack of creditworthiness of the bond issuers, who may default on interest payments. The Fund Manager's research would focus heavily on credit analysis, in order to identify corporates who are offering attractive yields coupled with enough financial strength to make timely repayments on interest and principal.

The second strategy would be "duration" based. A duration based strategy involves adjusting the average maturity of the bonds being held in order to make an informed play on future interest rates. When RBI drops rates, bond prices rise and vice versa - this is known as interest rate risk. The rise and fall impact would be in direct proportion to the average maturity of the bonds being held. Hence, if a Fund Manager feels that interest rates are ripe for a fall, he would spike up the average maturity of his portfolio - and vice versa.

There are many types of debt funds available for an investor to consider. The universe includes Income Funds, GILT Funds, Dynamic Bond Funds, Liquid Funds, Fixed Maturity Plans, among others. The question that arises is - how does one decide which type of fund to invest into in order to maximize returns?

Interest Rate Outlook
The RBI is the key decision maker on interest rates, and adjustments made by them in the policy rates have a pass-through effect to the rates offered by banks, financial institutions and borrowers ("transmission"). The key consideration for RBI while reducing or raising rates would be inflation, which has a severe impact on the lives of the common man. Low rates encourage borrowing and growth, and hence are favored by corporates. Higher rates bring down inflation, and hence ease the pressure on the lives of the common man - in this manner, the melee continues through the years!

The RBI has reduced rates aggressively since January 2015 (a cumulative 1.5 per cent), which benefited funds that followed a duration based approach and maintained high portfolio maturities. For instance, SBI Magnum GILT Fund (Long Term) delivered a 24.6 per cent return in the 2 years leading up to 10th June 2016. The fund currently has an average portfolio maturity of 9.18 years, with the 1 year high going up to nearly 20 years. Similarly, ICICI Prudential Long Term Plan delivered close to 20 per cent absolute returns in the calendar year 2014; the fund maintains a high portfolio average maturity of close to 15 years at the moment.

In the recent 7th June policy meet, the RBI decided to pause rate cuts while adopting a mildly 'hawkish' (anti rate cut) tone in their policy note. This pause came on the back of higher than expected CPI inflation of 5.39 per cent in April (up from 4.83 per cent in March), a trend that's at odds with the central bank's CPI target of 5 per cent by March 2017.

Armed with a basic understanding of what how the overall macro scenario is shaping up, fixed income investors need to ask themselves two main questions - first, should they invest in funds which follow a predominantly accrual strategy or a dynamic (duration based) strategy? Second, what kind of average portfolio maturity should they be gunning for?

Suyash Choudhary, Head - Fixed Income, IDFC Mutual Fund offers his expert view in this regard. He says, "We expect the yield curve to continue to steepen as has been the trend over the past 9 months or so. Front end rates (1 to 5 years) should benefit from the RBI's new liquidity framework as well; whereas long end rates may be sluggish owing to lack of incremental disinflation."

Further, Choudhary goes on to advise debt investors to invest into short to medium term debt funds that follow an active duration strategy. "From a macro-cycle standpoint, we think investors should move away from passively run long duration funds. We don't think they provide as compulsive a risk to reward ratio as they did over the past 2 years. Active duration and short / intermediate bond strategies may offer a better trade-off", he offers.

Where are rates headed in the medium term?

In order to effectively invest in debt funds, an investor needs to have a basic understanding of where interest rates might be headed over the coming months. You need not be an expert in macroeconomics to do this; data on interest rate outlook from economists are widely published online, and your Financial Advisor can assist you as well.

Choudhary of IDFC Mutual Fund believes that we are more or less done with rate cuts for the medium term. "We think the rate cut cycle is broadly done. The key to further disinflation and sustained rate cuts rests with structural supply side measures by the government", he says.

Fixed Maturity Plans
Fixed Maturity Plans as a category aim to eliminate interest rate risk by buying a holding a portfolio of bonds until maturity. They have no element of 'duration based' plays, and simply aim to achieve an appropriate mix of creditworthiness and high yields in their portfolio. Unlike most regular debt funds, they are close-ended in nature and have strict lock-ins.

According to Choudhary, FMP's are best avoided at the moment. "We think short and intermediate bond strategies focused on the 1 - 5 year segments offer the best risk versus reward pay-offs. Investors don't necessarily need FMPs to participate in such strategies", he advises.
Arbitrage Funds as an alternative

Arbitrage Funds are not debt funds, but rather a category of equity funds that are low risk in nature, as they play on the price differentials that exist in the stock and futures market, thereby locking in risk free returns wherever they can. As a category, they have returned in excess of 8 per cent per annum in the 3 years leading up to June 2016. Since their returns are taxed as equity, they essentially become tax free within a year. An 8 per cent tax free return in an arbitrage fund is equivalent to an 11.5 per cent debt fund return for an investor in a 30 per cent tax bracket. Are they a viable alternative to debt mutual funds for investors with a 1 year horizon?

Choudhary's expert view is that investors should opt for short to medium term debt funds over arbitrage funds at the moment; despite the latter offering more tax efficient returns. "While taxation is an advantage, arbitrage funds will not hedge re-investment risks for an investor if money market rates continue to fall. For that reason, we think investors should also hold short and medium term funds", he says.

The bottom line - where should a debt fund investor's money be right now?

Avoid FMP's and passively managed long duration funds for now. If you must, allocate only a small portion of your debt portfolio to GILT's. Concentrate your debt funds in short to medium term, actively managed debt funds instead. Consult your Financial Advisor on which funds in this category will best suit your risk profile, time horizon and future objectives.