Mutual Fund

AT1 & Tier II Bond Risks hiding in plain sight!

“The best approach here, if at all possible, is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset-price bubble bursts in the future.” Ben Bernanke

I am a strong believer that the Indian financial regulatory environment is managed quite well. The way Indian banks are regulated and monitored, it has resulted in the history such that no consumer of a bank has faced the loss of capital over last 2 decades. Even though the bank failures/ mergers have happened, still it has been a largely salvageable situation. In recent times, banks like Yes bank or Lakshmi Vilas bank has gone through the restructuring and it has exposed one of the risk associated with the Additional Tier 1 (AT1) bonds. Recognizing the same risk, SEBI has come out with a proactive regulation to limit this risk exposure for Mutual Fund investors. This in my view, is a very welcome move as a regulator to protect the retail investors capital.

SEBI in it’s circular dated Mar 10, 2021 has addressed this issue. Currently, There is no limit on exposure to such bonds by AMCs in their funds. SEBI has prescribed that Any AMC should not own more than 10% of such instruments issued by a single issuer. Also, Individual Mutual Fund scheme shall not invest more than 10% of its NAV of the debt portfolio of the scheme in such instruments and shall not have more than 5% of its NAV of the debt portfolio of the scheme in such instruments issued by a single issuer. These are significant limits as in current situation there are 22 funds that have over 10% exposure to AT1 and perpetual bonds as on February 2021. (Source: Morningstar India) As per the regulation, the current exposure would be grandfathered and AMCs can make fresh investments in the perpetual bonds only once their exposure comes within the prescribed limits.

Though the clause of grandfathering would not be much useful for debt funds which have restriction on their Macaulay duration like Low/ short or Medium duration bond funds as per Oct 2017 circular by SEBI. As the AMCs have to value the perpetual funds with maturity of 100 years, the Macaulay duration is set to be changed drastically. Even though the clarification given on Mar 22, 2021 has updated the maturity applied to increase in phased manner, still the impact might be significant.

For e.g. the Low duration funds should have Macaulay duration of less than 1 yr. HDFC Low duration fund has exposure of 11.74% to perpetual bonds. One such bond is STATE BK OF INDIA 8.75% S-II perpetual bond. The bond has the issuer call option for Sep 2021, which means if issuer calls to redeem this bond it will mature is 5 months from today so it’s maturity is <1yr. Though if we have to calculate the Macaulay duration of this bond as per new regulation the maturity as 10years & expected YTM of 8.7% for AA+ category bonds, it comes out to be 7.06years. Therefore, 12% exposure in 7Yrs Macaulay duration would make the portfolio Macaulay duration of 12% * 7 = 0.84 and this means the fund should have the remaining 88% of the portfolio with maturity of <0.2years. This is quite difficult to achieve and the fund have to make lot of changes to adhere to the new regulation of valuation of perpetual bonds along with maintaining the Macaulay duration of <1yr.

As I have mentioned earlier (Investing in TINY world) that at present it does not make sense for having duration exposure in your portfolio. The current regulatory change would increase your exposure to interest rate risk. You should review your funds in your holding and probably opt for one of the actions as per me. Exit should be done in optimal manner to have lower tax/ exit load impact.

  • If the portfolio holds <5% of assets in form of perpetual bonds, you should not worry and consider the fluctuations in it’s NAV as part of market risk you have signed for
  • If the exposure is 5-15%, and your debt fund is of Low/ Short/ Ultra Short duration or 15%-20% in your Banking PSU/ Medium duration fund then there is problem as the fund has to value funds with assumed maturity of 10 years in short run. This will increase the interest rate risk as well as Macaulay duration of the fund so the fund houses might have to reduce the exposure. This would have an impact on NAV and if you have a really large exposure, you should contemplate reducing your holdings (Speak to your advisor/ distributor)
  • If your fund has >20% exposure & your have significant investment in such fund than consider to get out of such fund

It is important as an investor to understand such products in details. Attached link shares the details of such perpetual bonds, which clearly states its risk (refer the term sheet from page 78). These bonds are Non-convertible, Perpetual, Taxable, Subordinated, Unsecured. each term in it’s definition poses a risk. If you thought that the interest rate on bonds is higher and probably covers for the risk, I would recommend to read page 86 for Coupon Discretion & Page 88 for Loss Absorbency. The coupon is discretionary as well and if issuer needs to cancel the coupon, it can with no recourse available to bond holders. Hope this helps you understand the positive intent of SEBI to limit exposure to such bonds.

Lastly, Don’t just think that the regulation is going to impact just the debt funds. It will also impact your Hybrid aggressive funds as well. Even though there is no Macaulay duration limit applicable to such funds, They would have to comply with the 10% upper limit of exposure in the debt portfolio. In simple terms, I would interpret this as follows: “If the Hybrid Aggressive fund has 25% exposure to debt than no more than 2.5% of the portfolio should be in perpetual bonds.” If my interpretation is correct, this might be a bigger trigger of upheavals in aggressive fund category as all of the Top 3 funds (SBI Eq Hybrid/ HDFC Hybrid Eq & ICICI Pru Eq & Debt) by AUM have >3% exposure to perpetual bond funds. ICICI Prudential Eq & Hybrid has the higher exposure among the three funds 9.53% of the fund AUM as of Feb 2021. Similar would be the story in Balanced advantage funds or conservative hybrid funds.

In Summary, Please do no invest and forget your investments. Keep monitoring for the impact of such regulatory changes and make the necessary amends in your portfolio. If you find it difficult to monitor your portfolio at your end, speak to your advisor or distributor to understand such impacts or stick to simple products for investments which avoid such risks. It is your money and your responsibility to monitor the same. Happy Investing!

Write to us or leave a comment, if you want to enquire about any specific fund in your own portfolio. Feel free to share it with your friends & family, if it helps them or educate.

Mutual Fund

HDFC Hybrid Equity: Tough to replace

Over the last 3-4 years, I have simplified my portfolio and finally had only one equity fund in my core portfolio “HDFC Hybrid Eq Fund”. The exposure to this fund was pretty high and so were the losses in the recent fall. The losses were so tempting (yes tempting) that if i sell my holding, I could make my capital gains tax in the current FY to “0”. I had two options:

  1. Sell my current equity fund and then buy the same
  2. Sell my current equity fund and then buy a better available fund

Obviously, I didn’t want to cut my exposure to equity but increase it. I am sharing here my approach and analysis i did on historic data to pick the fund for Core portfolio. I decided to explore Option 2 because i knew, if i wont change the fund now then i might not change it for another 4-5 years due to lethargy. Also, This was one of the valid reasons to sell your funds.

Should i replace it with an Index fund?

I am sure, you would have heard the benefits of index funds. Lot of articles claim that the index funds are a good starting point including the “Mutual Fund Sahi Hai” campaign suggests Index fund as a starting point. Those who don’t know about index fund: “Index funds are passive funds, The mandate of Portfolio Manager is only to keep the holdings of various stocks in mirror fashion to the Index it is tracking. Two main indexes in India are NIFTY 50 or BSE SENSEX.” The usual benefit touted for index funds are lower expense ratios and no large under-performance vs the actual index. This was tempting and i thought to explore it. I picked the HDFC Index Nifty 50 fund, it has the long available history since the start of 2002 to compare with HDFC Hybrid Equity Fund.

Approach: I took the daily NAVs for both the funds since the start of Jul 17, 2002 to Mar 25, 2020. Calculated the rolling returns on a 5 yr basis for all possible 5 yr periods starting (for e.g. Jul 17, 2002 to Jul 16, 2007). I have also calculated the maximum draw downs for each of these 5 year period.

Results of Return Profile: There were 3000+ such rolling returns so to compare the results, i used the parameters like Geometric Mean of observations, Median of all observations, Minimum returns and Maximum returns. You will notice the out-performance of HDFC Hybrid Equity over the HDFC Index Nifty 50 fund. Though i might have to sacrifice some upside if it is going to be a bull market because the maximum possible return in historic data for HDFC Index Nifty 50 is higher vs the HDFC Hybrid Eq.

HDFC index vs HDFC Hybrid

Results of Risk Profile: Some people will come back with the explanation that the out-performance is due to higher risk. So i also, looked into the risk profile using parameters like Standard deviation, max draw downs (MDD). I have calculated the MDD for each 5 yr time period to compare the lowest MDD or highest MDD among these 3000+ data points. You will notice the HDFC Hybrid Equity outperforms HDFC Index Nifty 50 on the Risk profile as well.

HDFC index vs HDFC Hybrid Risk

The last argument (which i also agree to an extent) is that as India market becomes more mature, Outperforming the index will be a challenge for active funds. Therefore, I looked at the history of these 5 yr returns to see the extent of out-performance (HDFC Hybrid Eq – HDFC Index Nifty 50). You will notice that HDFC Hybrid equity lagged the index returns in the initial phase, Then it continue to outperform for almost 10yrs.

HDFC index vs HDFC Hybrid Outperformance

The extent of out-performance has been deteriorating. Though it is still an out-performance with a lower MDD as well as volatility. Since, the data still points out that having an active fund is a better option, I ditched the Index fund again for couple of years.

Which Category of Active Fund should I Opt for?

This is another challenge that if i have to pick an active fund, Which category i should look for? In an article couple of years back, I highlighted the basics about how to build the Core & Satellite Portfolio. Over last year, I have also reviewed all the main categories of equity fund Aggressive Hybrid, Large Cap, Large & Mid Cap, Multi-cap etc, This has helped me get the foundation ready. Below is the approach i followed.

Approach: Let me start by saying that I did not consider Mid-cap funds for Core Portfolio as they are more risky & volatile and Small Cap funds are not for me. My heart was to move towards Kotak Standard Multi-cap fund after all they have ~30,000 Cr Assets under management in one fund. I picked the funds history from the start Sep 11, 2009  to Mar 18, 2020 and also compared it with the two best funds in each of the 4 categories which already reached by considering parameters like expense ratio/ turnover, AUM, Upside/Downside capture ratios etc. If the funds were started after Sep 2009, I did not considered them in the analysis. Here are the funds i compared against each other:

  1. Hybrid Aggressive: ICICI Pru Eq & Debt Fund/ HDFC Hybrid Eq
  2. Large Cap: ICICI Pru Bluechip/ Nippon Large Cap
  3. Large & Mid Cap: SBI Large & Mid Cap/ Canara Robeco Emerging Equities
  4. Multi-cap: Kotak Standard Multi-cap/ SBI Magnum Multicap
  5. Nifty Index 100 TRI (I don’t want to under-perform the Index so have to keep one Index)

Results of Return Profile: There were 1300+ such rolling returns so to compare the results, i used the same parameters Geometric Mean of observations, Median of all observations, Minimum returns and Maximum returns. You will notice that all of these funds have beaten the Nifty 100 TRI Index. This helped me build my confidence to stick with an active fund. Except Canara Robeco Emerging Equities, funds were having mean returns in range of 14-17% and it is also important to understand if the risk of these funds are quite different or same.

Core Funds Return

Results of Risk Profile: I looked into the risk profile using parameters like Standard deviation, max draw downs (MDD) in similar manner.

Core Funds Risk

To make it easier for to visualize, i used the Risk vs Return chart for these funds, as below. You can now see that Canara Robeco was definitely most volatile in the lot, though its out-performance across funds were also astounding, For this fund, the volatility is an imperfect metrics because the lowest return (5.3%) for it was also the highest and so was the max return (35.3%).

Core Funds Risk vs Return

There are only two funds which had lower risk vs HDFC Hybrid Eq, Though the returns of ICICI Pru Bluechip are lower vs HDFC Hybrid Eq so it is not worth considering. If i agree to take more risk, I should ask for higher returns and Kotak Standard Multi-cap does meet that criteria. After this exercise, I came to below possibilities:

  1. Reduce risk with similar returns: ICICI Pru Eq & Debt
  2. Take More risk & more returns: Kotak Standard Multi-cap or Canara Robeco Emerging Equities

As of today, I finally moved out of HDFC Hybrid Eq completely after an association of 10yrs+ and replaced it with one of these funds. The analysis here is not authoritative and obviously do not promise me future returns. It also do not cater to things like change in mandate or Fund manager etc etc. Though this gives me the peace of mind, That i am making a decision based on my analysis and understanding and it did help me improve my understanding of the investment options. Hope, i will be again in for long haul with >10yrs this time.

Happy Investing!!