The Mutual Fund Show: How RBI Rate Hike Impacts Debt Investments

Amit Bivalkar: We have been saying this on your show for quite some time that there are two factors that we need to consider when investing in debt, one is cost of money, and one is availability of money.

The cost of money has been going up and we all know that inflation is the killer there. So, unless and until you raise rates and kill demand, inflation will not come down. So, the RBI and central banks across have been doing the same and they have been raising the rates there.

You have seen over the last one year; the rates have gone up to 6.5%. So, we have clearly seen a change in cost of money. Through the policy, what I could gather is that the availability of money, which was ample six months ago, the Governor has reiterated that they are going ahead with sucking out the excess liquidity which is there in the system.

So, on one side you have the cost going up, on the other side you have the availability which will come down and I think that's why we were sitting in a rolled-down kind of fund, which is maturing this March. Since last April, where you are getting a higher accrual on those the reset cost was low, and now when it resets itself in March, you will have accrual anywhere between 7 to 8%. So, nothing new in the policy was according to our expectations.

I think the RBI is doing a fine job and availability of money, the sucking out of liquidity is yet to happen. So, you will see the rates moving up. It was ironic Niraj, if you remember the home loan borrower was getting credit at a cost cheaper than the government of India one year ago and that has corrected. So, the rates we feel will stay elevated and you need to maintain a rolled-down strategy along with the yields and capital gains back ended.

Feroze Azeez: No, it doesn't alter, and I think this whole policy and its impact on debt funds or debt investments is far overdone than it actually is.

Let me give you some numbers to substantiate the point which I am making. It is so exaggerated, the impact of policy rates on debt funds or debt investments, so much so let's assume this, May 5^th last year is when we started increasing interest rates and we moved it from 4.5% to 6.5% today. That is one of the steepest rises in the policy rates which generally tamper with the short-term interest rate, does not tamper with a three-year, five-year, 10-year right, repo and reverse repo, not long-term rates.

You will be surprised to know that the 10-year G-Sec is exactly where it was on May 5^th. 7.3-7.38% was the number and we have seen 2.1% jump in policy rates and near zero jump in 10-year G-Sec and this is one example I am telling you.

Take history of 20 years and you will realise there is no correlation, this is the longest probable standing myth in the financial system that short-term ends of the yield curve can impact your debt fund money.

I might be exaggerating a bit because it's on the other side, I am trying to bring rationality to participants, I have heard so many ultra HNIs and I have a person who has Rs 1000 crore, he says I am waiting for a policy rate hike so that 10-year G-Sec goes up and I will enter. I said why are you thinking they are correlated variables, where you have the evidence or what's the measurement of that correlation.

Feroze Azeez: From my perspective, like I agree with Amit saying that we do roll-down and that's a great strategy. In my opinion, people spending too much time in debt is not right, that's our opinion, because debt has to be low cost, no interest rate, no mark-to-market risks in terms of models.

What do I mean by that is, that we go only with sovereign G-Sec, because those are very liquid instruments. Liquid instruments make sure that the NAVs are efficient. Anybody entering and exiting is not disturbing my rolled-down fund because ETF, like for example, Bharat Bond ETFs collected Rs 30,000 crore at NFOs but it's at Rs 60,000 crore. I might hold it till maturity, but the underlying instrument might not have great liquidity that the NAV is efficient. Like PSU bonds might not get traded every day, the same way ASIs doesn't get traded.

So, low cost, rolled down, that the central government will give you an efficient NAV. That's been our strategy 10-15 paisa expense and use your mind share on equity or to create more value than debt.

Amit Bivalkar:  I feel that why people keep their money in debt, for liquidity and because they don't have a view on equity, because if they have a view on equity, nobody will go in debt.

So, if you are bullish on equity, you have seen that cheaper money moves into equity because your yields are down. Now when your yields are up and your margins will come under pressure, because anybody who borrows, be it a SME, a MSME or a corporate, his cost is going to go up and his costs going up effectively means his profitability or EPS is going to come down. Now when that's the case, people are generally bearish on equities and when you get 7-8% in a debt fund, you will obviously shift your money from equity to debt.

So, we have seen some ultra-high net worths locking in their yield that 7-7.5% for a period of three to five years and I think that's the right strategy because you need to take some money off the table from equities at times. So, the cost of money going up, availability coming down, yields attractive, people definitely move into locking their yields for three to five years.

Feroze Azeez: By no stretch of imagination am I saying that debt is not a great instrument. I am just saying don't spend time, you want to put 50% in debt, please go ahead, put 80% in debt, but there's no point spending time because you can just get government of sovereign paper with 7%-7.4% post expense. Post tax you can get 6.8-6.7% assuming 5% inflation, then why would I spend time, if I can get an equivalent of a 10% FD by not applying mind.

Why I implied 10% because 10% minus 30-35% tax for HNIs gets you to 6.6-6.5%, that's what I meant, not a lesser allocation to debt, to each their own, like you said from an asset allocation point.

Now coming to your pointed question on this fund, I personally think, if it's a gilt paper, which is what it is, 2032 is a nine year paper. Great thing to do, anybody who has money is going to be in debt, that's if you can lock in monies for nine years, the agnostic, to the mark-to-market gains or losses, then it's a great thing because your yields are going to be upwards of 7.2-7.3% after expense in this fund.

So, if I can lock in 7.2-7.3% for nine years, provided you have the courage to not get too perturbed with the NAV movement, which could be that you can invest for two years, three years and then realise that you have made only 4-5% return. The residual period will make up for the lost time and the lost returns, if you hold it till maturity. Since it is gilt, the yield dilution because of entry and exits of others, does not change my yield that much.

Amit Bivalkar: If you go back in history, the year 2000, you had the 8% RBI tax-free bonds which used to come for a period of 10-12-15 years. I think if you are comparing this with credit quality, then you have the highest quality here because we are having the government of India papers.

My only concern with target maturity versus fixed maturity plans is that in a target maturity, you might have lumpy investors come in or go out. So, you might have a mark-to-market impact, which you might see on a temporary basis if you are not holding it till maturity. But in case of a fixed maturity plan, you cannot enter, or you cannot exit.

So, you cannot do anything about your portfolio and therefore where there is mark-to-market in debt, your portfolio is actually like a soap, the greater number of times you touch it the smaller it becomes.

So, if you have an FMP versus a target maturity fund, I will prefer a fixed maturity plan because then I stay put all through. In a target maturity fund, if there are large exits and even though it's a government of India paper, on a bad day, you might have less liquidity and more redemptions, you might have NAV which might get shot down.

That might be a good day to enter, but people who are staying in the fund might have a shot temporarily on that day. If you are holding it to maturity, you need not worry about what is happening to your investments, mark-the-market thing gets evened out by the end of the tenure.

Who is it beneficial to, I think anybody who is at the 30% plus tax bracket. Anybody who is getting 7% assured return because this is like the target maturity, we will get that particular return at the end of the tenure and plus because of indexation, you might end up getting a 6.8-7.2% kind of a tax-free return, if the indexation stays at 4%.

So, if you are looking at such kind of an instrument and you don't need liquidity for 10 years, you want to build a debt portfolio for 10 years, then you can clearly go and lock it. Why I am saying for people at 30% plus tax bracket because for people at 10-20% most of the banks are offering 7.8-7.9% today on the fixed deposits and as we go into the first quarter of the next financial year, I think this will add some more basis point for the fixed deposit holders.

So interestingly, if you are getting calls from people last year for loans, this year the calls are for deposits rather than for loans. So, I think the rates are going to go up and therefore people in the 10-20% bracket, fixed deposit might still be a better alternative. For people in the 30% plus, such kind of funds can give you a better post tax return, although I prefer FMP or a target maturity fund.

Amit Bivalkar: No, I think you need to look at the credit profile of the fund. You have to look at the maturity of the fund. Most of the debt fund managers now do have a great credit profile. Generally, people avoid going into sub-credits. They generally have an AAA credit and AA+ they don't go below that.

So, if you have a 3-4 year, like you are in the month of February, if you do a 38-month FMP today, you will get four indexations by investing only for 38 months, and in those four years, four indexations, you might end up getting a 7.4-7.5% kind of a yield and after four years we don't know whether rates are going to be down or up and we can take a call then as to where that money should go because if the rates are down that means that equity has started to do well, if the rates are up, then you get a reset at a higher valuation.

Feroze Azeez: There are available options. Anybody could get into a target maturity fund. A 9-year paper, this one which you have is April 2032, which is practically a little over nine years. You have in the IDFC umbrella itself you have IDFC Gilt 2027, you have IDFC Gilt 2028. If I am taking a 4-year paper of government of India alone, I would be feeling very safe that the liquidity is going to be immense, the mark-to-model will be very low on impact.

I don't like the extent of spreads today, between G-Sec and SDL or SDL to PSU, PSU to AAA, the spreads are so compressed that it is not motivating enough for me on the credit to spread myself in, or on the term to go, the motivation for me to lock in a 20-year paper and a 10-year paper is also one of the least, below the mean, now two standard deviations below the mean.

So, the point that I am trying to make is that you are going to have a three-four-five-year target maturity fund. If it's a target maturity fund, you don't have to wait. But I completely concur with Amit that FMP, if it's available and it's timing with your liquidity, then definitely locking in for two-three-four years is okay. 9-10 years, we have seen six AAA corporates actually defaulting for the last three years. Ironically, the Franklin portfolio, which was absolutely unrated, all of them have paid up and there have been six defaults on the AAA side.

So, when you put it in an FMP, even if you look at ratings, ratings of a corporate change over periods of time, so I don't like FMPs of longer periods which I can't react to, unless it's G-Sec, I would love to take Amit’s advice and lock in with FMPs.

Amit Bivalkar:  I think there is a distinction here between listed MLD and unlisted MLD. Market-linked debentures, which was listed, the loophole there was that the issuer used to do a buyback before maturity, one month before maturity do a buyback and you are taxed as long-term capital gains and you were paying equity long-term capital gain on that and hence you are getting away with a 10% tax.

Now, because of section 58AA which the budget has introduced, this is now going to be taxed at short-term capital gains debt, which means that it will be according to your tax slab, and therefore this has become unattractive.

What one has to consider is that, there will be a lot of HNIs who might contact the issuer for a buyback before March 2023 and according to me, that might put a strain on the issuer as well, because there will be a liquidity crisis and they are not mandated to buy back. But some of the HNIs, whom I have spoken to, have said that we have asked for a buyback before March 2023.

Basically, when you are investing in an instrument, are you looking for maximisation or are you looking for optimisation of returns. So, when you are looking for maximisation of returns, obviously there is an element of risk, be it regulatory, be it from the budget or be it from anywhere, it's going to be there.

But when you are looking at optimisation of returns, I think there are some unlisted MLDs in the market which are from day one unlisted and therefore they were paying full tax in which case I don't see a problem for those MLDs. But some who were listed and had a 10% long-term capital gain being applied, people have actually asked for a refund. So that's the loophole which the budget has plugged.

How much are you getting from such kind of instruments on a listed MLD, maybe 8 to 10% is what you are getting on a listed MLD, as post tax returns. As we are talking of target maturities and FMPs, in a debt portfolio without linking to the markets, you are getting a 7 to 7.5% return.

So, I think if you invest before March and you have the money and you are willing to stay for that 38 months, you are going to get that 7% post tax, so maximisation or optimisation, because wherever there is greed, there is risk. Whenever there is risk, you are going to lose some.

So, I would say that you have a great opportunity to invest in debt, if you have a three-four-year short-term fund as well, with a roll down, I think you will make handsome returns.

You have yields which are attractive today even on the shorter end. So do a combination of one year of rolled down on the shorter end and do a four-year kind of maturity on the longer end.

In the middle, you will get a handsome return because you will have capital gains on that short-term fund, and you will have yield on the short-term end. So, my suggestion will be that debt offers a great perspective today and you can definitely move to debt and stay with the help of indexation.

Feroze Azeez: A lot of people have asked me because we were popularly known for our MLD issuances. But we have been very clear, in fact on July 11, 2022, I released a note which categorically said this, that it is a glaring anomaly that our debt ETF which is listed, waits for three years and pays 20% and it is also debt, it is also listed, no STT, another bond which pays 10% one year.

This was one of the biggest anomalies and that's why you will see that 1583 outstanding issuances of mine between internal and external issuers, none of them are taking the benefit of 10%. That's how clear we were that in the next few budgets it will get plugged/blocked.

All the 1130 odd which matures also didn't take this benefit, because of benefit which is a loophole to my mind is not something which you should harp upon, like the maximisation and optimisation theory which Amit said, which I completely concur with, that's point one.

Point two, I think aggressive selling will not happen because this taxation is retrospective, there is only one financial instrument which has the power to lock in tax at entry, all other instruments are subject to tax rules of exit. One instrument is insurance, so there is aggressive selling of insurance to lock in the taxation of the current regime for policies sold today. So, aggressive MLD selling will not happen.

In fact, now there are several so called MLDs that are no more MLDs, now that we have a definition to an MLD in the Income Tax Act. There was never an MLD, so I think the key distinction is non principal protected. If your principal is not protected, then you can't even categorise itself as debt. So that's why I am not too worried. In fact, the Rs 1.2 lakh crore listed industry which had several NBFCs who were using this may find it difficult.

I think Section 58A does not speak of long-term even after three years, which is surprising. That's largely because most of the MLDs which are listed are maturing before three years. That's why I think, that's my guess, the ministry didn't spend time to find out when these should become long term, especially when all the instruments are of 14-15 years average period. That's why, maybe Section 50A would be silent and overriding the other long-term sections which are available.

Feroze Azeez: To my mind, even if somebody owns the principal protected listed MLD, I don't think the marginal tax rate is 30%. In India, in the new tax regime, if you have Rs 30 lakh of income in a specific year, your taxation is going to be Rs 6 lakh.

Every HNI family will have four files, five files now you will have major children where clubbing provisions are not applicable. So, the point is, if you plan your taxes properly, I saw newspapers writing that now listed MLDs will be taxed at 39%. 39% is something which is so academic, you can compute it.

Only for the salaried you can optically say what is the tax. So, if you have four or five crores of principal protected listed MLDs and if you have a family of four, five, you are not entitled to pay more than 20- 25% anyway if you plan it right and legitimately being in the absolute wide zone of taxation.