Mutual Fund

Investing in a T.I.N.Y. (There is No Yield) World

“Every portfolio benefits from bonds: They provide a cushion when the stock market hits a rough patch.” – Suze Orman

Indians are obsessed with fixed deposits. As per the latest data by RBI, 55%+ of financial assets by Indian households are held in form of deposits with banks. In the recent years the rate of deposits have come down drastically, 2years back I was able to make the deposit with the bank @8% returns but now that interest rate has come down to ~5%. The fixed deposit investors are out scouting the other better avenues and Debt Mutual funds are getting explored by many. We can not deny the importance of Debt as an asset class in our portfolios but managing it well is also very important. Today we will try to workout, possible good alternative options to build the debt exposure using Mutual Funds.

Though First thing first, Should you opt for Debt Mutual funds or not. This point need more attention and I tried to cover a lot over the last two years in How to Build the debt fund portfolio.

  • If you are employed individual investor and investing for retirement goal, EPF should be your go to option. You can increase investment by using VPF & Yes, even after the new rules of tax on contribution in excess of 2.5lacs per year will attract tax on gains
  • If you are investing for your 15-20 year horizon, PPF is next universal venue available to every resident to invest up to 1.5lacs. Married couples can have separate PPF accounts to invest up to 3 Lacs each year
  • If you have daughter of age <10yrs, you can also opt for Sukanya Samridhi Yojana. Even though the maturity profile is 21yrs, but at 18yrs you can take some amount out
  • For elder citizens >60yrs, There are couple of more relevant options for them in form of Senior Citizen Saving Scheme (SCSS) & Pradhan Mantri Vyay Vandan Yojna (PMVVY)
  • If you are in lower income tax bracket of <=10% then it is ok to stay with your traditional options of NSCs, Post office Investing. There is no point of adding risk to the portfolio for smaller gains

If non of the above criteria are met or options available, Which means you have short terms goals up to 10-15 years or your income tax rate is higher and for higher savings requirement you need to add exposure to debt in alternate options. Let me clarify that investing in endowment insurance plans with higher premium is not a wise choice. Mutual Funds are good tax efficient options to manage for such goals specially for people with higher tax slabs.

Before we try to zero down on the category of funds, Let’s understand the two main risks associated with Debt funds; Interest Rate Risk & Credit Risk (For more details: Check This). There are 16 main debt fund categories as per SEBI Guidelines, I have tried to map these on broad basis across the two axis with increasing credit risk (Left to Right) and interest rate risk (down to up). The fund which is farther from the origin have the highest risk, in below map credit risk funds have higher risk of default and also have interest rate risk. Gilt funds invest in bonds from Govt of India with assumed no default risk but they rank higher on the interest rate risk, while the Overnight funds have the lowest form of interest rate risk as well as credit risk. The chart is median presentation so you will have funds in each category which have higher credit risk vs others, so one has to manage and monitor their funds exposure regularly.

After the IFLS, DHFL & Franklins episodes of credit risks in 2018-2020 period, The credit risk funds have been discarded by the investors. Lot of Advisors & Distributors have also become risk averse and prefer advising for funds like Liquid funds, Low/ Short duration funds in majority of the cases or for longer time horizons 8-10yrs or more suggest to invest into Gilt funds to avoid credit risk. Let me state that I am against the suggestion of investing in Gilt funds for Investors who do not manage portfolio regularly.

Gilt funds (Grey bars) vs Money Market Funds (Golden bars)

Check the above chart you can change the reference to Money Market funds return vs Gilt funds returns. You will notice that for multiple period the return of gilt funds go for negative or near zero returns as well as to high double digit returns. Though over a period of last 20yrs history the mean return has been 8.1% but have a high volatility (STD Deviation) of 6.5%. More often, I find people jump off the ship in the period of zero/ negative returns. While the returns of Money market funds over last 20yrs have the mean of 7.3% with lower volatility of 1.5%, Returns have stayed in the zone of 5% minimum to 10% maximum. Therefore, If you do not time your purchase of gilt funds then you might be up for a bad experience in investments. There are portion of interest rate cycle, where investing in gilt funds can be rewarding. Lot of investors, look at the recent history of fund returns while buying the fund which is quite a wrong approach. I discussed the steps to analyze the Yield to Maturity (YTM) of the bond funds in Debt Funds 2.0.

We can time the bond funds by following the interest rate cycle. Two things are required to time, One is our position in the interest rate cycle and another is the modified duration of the available funds. My assessment of interest rate cycle is that we are almost at the near bottom there is very less chance of the further decrease in the interest rates but might increase by 1% or more over the next 2 years. Also the possibility of increase is more certain (Which could be delayed or accelerated by RBI) because of below three pointers:

  • Restoration of cash reserve ratio (CRR) dispensation of 1% of net demand and time liabilities (NDTL) given last year to be unwound in 2 phases of 50 bps each beginning late March and late May
  • Additional 1% of NDTL dispensation given on statutory liquidity ratio (SLR) for availing funds under the marginal standing facility (MSF) extended by 6 months to end in Sep
  • Held to maturity (HTM) hike of 2.5% for SLR securities acquired between September – March, now extended by 1 year to 31st March 2022. Accordingly, eligible SLR securities are now expanded to include securities acquired over FY 22. Importantly, this relaxation will now start unwinding from the quarter ending June 23

To assess the impact of such interest rate increase, you need to check the modified duration of the fund which is published in the fund fact sheet as well as can be accessed on portals like Value Research Online etc. Let’s take an example of gilt fund (Axis Gilt fund), It has given a fantastic return of 12%+ over the last one year. Though if you will check the details, It has a YTM of 5.9% with modified duration of 7.2yrs. If the interest rate increases by 1% over next 12 months, The bond value will decrease by 7.2% and this will result in negative returns (+5.9% – 7.2*1%). If the interest rate increases by 0.5% then also the returns will be very low (+5.9% – 7.2*0.5%). Therefore, It is essential to have funds with lower modified duration & High YTM with lower risk exposures. As the fund like Money Market will buy the new bonds to replace the maturing bonds with bonds of increasing rates, the overall return of the fund over next 3-5 years will be better vs Gilt funds.

Lastly, If you do not want to time the interest rate cycle then that is completely fine. The funds category I have flagged in the center of the Risk Map are evergreen from my point of view (Corporate Bond funds, Banking & PSU funds and Medium Term Debt Funds). Over the last 20 yr period the mean returns of fund have been 8.4% for Medium term bond fund with 4.5% volatility (Higher return vs lower risk in comparison to Gilts). One can buy a good fund from this category and stay invested for long term. In Summary, If you are investing new money into debt funds then stick to Money market or Low duration bonds funds at present to avoid the impact of interest rate risk.

Let me know in case of any questions or feedback. Till next, Happy Investing!

Mutual Fund

Debt funds 3.0: Risk, Return and Relationship

“Good Judgement comes from experience, and a lot of that comes from bad judgement.” – Will Rogers

It is often said that your past experience shapes your future reactions, it can be best described with the proverbs like “Once bitten twice shy”. In the recent saga of NBFC’s default, liquidity squeeze and debt funds given large negative returns, I was completely unscathed from this fiasco even after heavily invested in this category of funds. This made me ponder on whether it was just pure luck or some actions/ judgement of mine which was build on past experience. After the careful analysis of my approach to investments made me realize that i am quite risk averse given my age,  income and liability profile. I was able to pin it down to one of my past experience. I do believe that either you learn from your own mistakes or from someone else’s, I am sharing my experience so you can learn from the later than former.

It pertains to the period 1993-1999, the period of high growth and lot of corporate in India were raising the money in form of corporate deposits. They recruited the large number of distributors for commissions and returns promised were in north of 20% YoY. Most of you will instantly think that this was a poonzi scheme but lets think from the perspective of the person, who have limited financial experience so far and extra returns are always luring. (#As some of you were lured to invest in ULIPs/ Small Caps etc in hope to make >15-20% returns.)

One of my mom’s cousin approached her with this scheme to double the money in 3 years, she could not muster the courage to propose it to my father so from her pocket she decided to deposit 500 Rs in the scheme. After three years, when she got the cheque for 1,000 Rs and it makes her quite happy so finally she decided to put all her savings in that options increasing the exposure to 3,000 Rs. After next 3 years, she got the cheque of 6,000 Rs. Now she decided to tell my dad about it, convincing him that over last few years she doubled it twice. This time they together put down 12,000 Rs in this scheme, thinking this will be used for me & my elder brother’s college fees. Alas, this time they were not lucky and after a year the news that company is not returning the money to people whose deposits were due. We started to follow up with my uncle and initially he says it is temporary but later he started to escape us. The local branch of the company started to close down, and in one more year we started to get the news of cases piling up with the consumer court against company for fraud. the last deposit was in 1999 and by 2004 the cases have reached supreme court. Since i have been vigilant to follow financial news, luckily i spotted that in 2018, honorable SC has passed the judgement to redeem 70% of the principal to investors by liquidating the real estate assets seized from the company and as we had all the documents we finally received 8,400 Rs after 19 long years. I have graduated as well as post-graduated along with my brother and this amount is just not enough for even one months of expenses.

To double money in 3 years means 26% CAGR so If we would have kept churning our money in same investment, It would have been 9.68 lacs in 19 years. If we should have bought Nifty, it could have grown to 1.07 lacs and sticking to simple FD @8% could have returned 51,700 Rs. in reality instead of gaining the money with high return we end up receiving only 1/6th of the amount we could have got in fixed deposit in bank and less than 1% to what was promised rate of return. Obviously we blamed the company as well as that cousin of mom. Lastly we made another mistake that we became too conservative in our approach and all my fathers savings were happening in bank deposits, LIC policies and Post Office Saving’s scheme, which again was a mistake (Learning from our parents). Let us understand the mistakes we made and what to learn from this incident.

#1. Never trust your money to any person (including relatives) unless they possess the right qualification as well as experience. You might see a lot of distributors of financial services including MFs, Insurance etc are not very well qualified and mostly understand only the operational procedures of their craft vs understanding the craft and its nitty – gritties.

#2. Understand the basic tenant on which the returns are promised or provided, if you do not understand then do not invest. It is always better to be safe then sorry, we often blame others for our losses but most often it is our greed which drives us to take such investments and repent later. You will see at least few cases every year of one or the other poonzi schemes like chit funds scam in WB or Shariah investment scam in Karnataka.

#3. Credit Risk is real and have to be avoided if you can not assess it. You can either stay with safer investment options (How to build your debt fund portfolio) or Debt funds with high quality investments. For later, in simpler way just go to value-research-online to check the quality of bonds the fund hold. Do not check it only while investing but keep monitoring at least once in a quarter to be aware of the change. In general any Investments in AAA/ A1+ category of bonds is relatively safe.

Debt quality check.png

#4. If you do take exposure to credit risk, it has to be as per your risk appetite as well as risk capacity. It has to be an informed choice in search of return where you know the payout if your gamble pay’s off and what is the expected loss. for example if i buy the ABSL Medium term debt, which holds a low quality bonds due to exposure to subsidiaries of Essel group to an extent of 17%. My 1000 Rs investment might lose full 170 Rs exposure to lower credit bonds, which in turn leaves me with almost zero return after 2.77 years (Assuming remaining 830 rs will grow @8% to 1,027) or if the default does not happen i might get 1,530 Rs in return (YTM of 16.66% over 2.77 years). This is an educated gamble to be taken based on your risk appetite. (Debt fund investing)

ABSL Medium Term Debt

#5. Interest rate risk is another component to understand while investing. Though it primarily is mark to market risk but it can affect your returns. If you know and can understand the interest rate cycles then you can buy bonds with Medium to long duration to generate extra mark to market returns in your portfolio. It is important to do it before the cycle starts vs doing in the middle of cycle as over a longer duration returns will converge to the YTM of the funds. (More to follow on this)

Lastly invest only in products and businesses, which you can understand because the risk comes from not knowing how to assess and manage risk. Hope this was a helpful learning for your investment journey.

Happy & Safe Investing!