The Mutual Fund Show: Pros And Cons Of Zero-Coupon Bond Funds
Assured returns on redemption is the primary selling point for zero-coupon bond funds, but investors need to be wary of caveats.
Assured returns on redemption is the primary selling point for zero-coupon bond funds, but investors need to be wary of caveats as well, according to experts.
In a scenario where interest rates have peaked, returns on products like target maturity funds can see substantial slippages due to reinvestment risks, Sandeep Yadav, head of fixed income at DSP Mutual Fund, told BQ Prime's Niraj Shah.
"For the zero-coupon bond that you buy in strip fixed maturity plans, it doesn't have any coupon," Yadav said. "So, you buy something today and you're just going to get everything back-ended as a principal."
In the current climate, investors are looking to protect their fixed income portfolio from uncertainty in interest rates and inflation levels.
Zero-coupon bond funds are slightly more efficient in "return generation ability" than target maturity funds, said Rohin Pagdiwala of Pagdiwala Investments. "The efficiency comes from the fact that there is no reinvestment risk and we're making the big assumption that interest rates have peaked out and from here on will fall."
"My expectation over a three-year product like this (a zero coupon bond strip FMP), maybe 5-10 basis points would be the difference between this product and target maturity fund."
While returns on maturity don't budge, there is a flip side to zero coupon bond funds as well, the analysts warned.
Yadav said zero-coupon bonds have a couple of risks and the biggest risk is a credit risk. "So, if you bought a bond and the company defaults, then you don't get that money," he said. "So, you have not got any coupon returns as well and everything is back-ended."
These are close-ended funds, which means investors cannot enjoy the flexibility of a product like target maturity funds. Strip zero-coupon bonds are illiquid since "you don't want investors to bear the brunt of liquidity in the market whenever it comes up", Yadav said.
Pagdiwala said investors need to make the choice based on their preferences. "When you need the money, there's the option to exit (the) target maturity fund, he said. "In an FMP, that option doesn't exist."
Watch the full interview here:
Edited Excerpts From The Interview:
Sandeep, can I start with you? What is the genesis behind this zero-coupon bond strip FMP?
Sandeep Yadav: I think one of the things that we noticed in the current funds that we have in the markets is that, of course, there are quite good funds, but one of the, I would not say negatives, but one of the, let's say, improvements that we could do on the fund is that these funds have reinvestment risk. So, whenever you buy a bond or whenever you buy any instrument in any debt fund, those bonds and instruments are coupons, which have to be reinvested whenever those coupons come. Usually they come up at six months or one year and six months down the line. When you have a coupon coming, you have to reinvest it and we don't know what the rate would be when you reinvest it six months from the time. The rates could be lower than your reinvestment is at lower rate. So, there are lot of target maturity funds in the market and they run this reinvestment risk. Now, of course, the reinvestment risk can work on the positive or on the negative side of the yields rise up, then your reinvestment is happening at the higher level. But usually, our view is that we are at a higher level of interest rates and, going forward in the next couple of years, you're going to see rates should be lower than where we are. If that is the case, then the reinvestment of these coupons is going to be at a lower rate and you might be entering a target maturity fund, expecting a certain return, but the slippages from that return could be meaningful. For the zero-coupon bond that you buy in strip FMPs is it doesn't have any coupon. So, you buy something today and you're just going to get everything back ended as a principal. Zero-coupon bonds have a couple of risks and I think the biggest risk is that they have a credit risk. So, if you bought a bond and the company defaults, then you don't get that money. So, you have not got any coupon returns as well and everything is back-ended. But in this fund that we talked about, we're just buying central government bonds, you're spinning them off, you're buying the G-Sec, so there's no debt responsibilities of the fund. So, to put a long story short, in this fund, if you are putting 100 rupees, you know exactly the last decimal point how much money you're going to get at the end of the maturity of the fund because there's no coupon and there is no reinvestment and, most importantly, it's a closed-ended fund. So, there's no impact cost of, you know, people entering and exiting through the next three–four years till the maturity of the fund.
Sandeep, in effect, you're saying that if people are uncertain about what could happen to rates per se, but the general belief would be that over the next two or three years, rates will be lower than where they are currently, then to take out the reinvestment risk. The product with the likes of what you said, which is zero-coupon bonds strip FMP is arguably a product that serves that purpose?
Sandeep Yadav: Absolutely and it gets much more certainty than any other product that at least I know in the market, which gives quite a lot of certainty to the end results that you will get.
Just wondering and then I'll get in Rohin into this picture as well. But just wondering Sandeep, what would the kind of returns be for a product like this part one, and how does it compare to say as you pointed out target maturity funds, which have been touted as the best ones, if you want to invest with a three-year view without taking the interest rate risk?
Sandeep Yadav: So, for the first question, I think today where we are sitting, I think the annualised yield should be more than 7.5% in the government security. It should be closer to 7.6% probably, depending on the maturity that we are looking for, but these are the annualised yields. As for the target maturity funds, they are good. Let’s be very honest, I am not saying that they are not good, we also have got a lot of target maturity funds in our stable. The advantage of target maturity funds vis-a-vis the strip is that they are open-ended funds, you can enter or exit anytime. The strip FMP that I speak about, the advantage of this is that there is no reinvestment risk, no impact risk of people entering and exiting, So, you have much more certainty vis-a-vis target maturity fund and about your final returns. The markets could move anywhere helter-skelter, your returns will not budge at all. So, these are the pros and cons. Of course, I might just take half a minute more and explain you know why strip FMP is not open-ended fund like a target maturity fund, and that is largely because the strip zero-coupon bonds are illiquid, and you don't want investors to bear the brunt of liquidity in the market whenever it comes up.
Okay, Rohin, thanks for being patient and just come in on this. What do you think of a product like this because, I mean, maybe not you individually, but advisors who come on this on the show so many times, have spoken about target maturity funds as probably the best panacea for moving out of this interest rate, differential risks that might come about and here we now have a product which probably does one better on that. How do you think about a product like this, not the DSP product, but in general the category?
Rohin Pagdiwala: So, the way to look at this the way I see it, and from a distributor point of view as well as an investor point of view, is that this is from return generation ability slightly more efficient than probably target maturity fund. The efficiency comes from the fact that there is no reinvestment risk and we're making the big assumption that interest rates have peaked out and from here on will fall. In that assumption, these products should do marginally better. My expectation over a three-year product like this, maybe five to 10 basis points would be the difference between this product and target maturity fund. Having said that, the concern that I have is that this is one big disadvantage is that it's locked in the product. So, for investors who are looking for flexibility, I would rather take five basis points less and have the flexibility of a target maturity fund. Otherwise, the point that Sandeep alluded to is the liquidity which is managed through the close-ended nature the product I think that is the other concern that we have, but if that gets addressed and then these are slightly more efficient products than target maturity funds provided you can stay locked into the entire tenure.
Just a small follow up Rohin, for target maturity funds as well, wouldn't there be a risk of return if indeed a person is looking for liquidity in that the mark to market may actually make the NAV much lower, if the investor is looking from a liquidity perspective, instead of staying put with the fund till the end of the tenure, which ways?
Rohin Pagdiwala: Absolutely. Absolutely. The recommendation is even in target maturity funds to remain invested through the tenure of course, but some investors will prefer the flexibility that you don't know when you need the money. When you need the money there's the option to exit target maturity fund, in an FMP, that option doesn't exist. So, for that marginal increase in return, it's a call that the investor needs to take on his preference one way or the other.
‘Agar chahiye to’ (if needed), I shouldn't be at risk, ‘agar mujhe chahiye to’ (if I need it), I should be able to redeem. Now Sandeep, my final question to you is that I heard you mention that the lock-in nature ensures that the investor is not exposed to the volatility in the price of the underlying asset, because eventually at the redemption stage, it will all be all kosher. Now, is there remotely an issue in previous instances or otherwise wherein things might have gone sour and therefore, the actual return, the eventual return does not match something like this. I haven't heard of a product like this before, but I may not as inform any way so as there's been a past history of something like this not giving the kind of returns that it has set out to do?
Sandeep Yadav: Before these kinds of products came, it is absolutely right, they were normal FMPs. They did not end up giving the kind of returns that they promised largely because they had coupon reinvestment risk that we mentioned, and the differences are as Rohin has pointed out that it could be five to 10 basis points. But especially during the Covid times, we saw that the difference between the promised returns or I wouldn't say promised but identified returns and the final returns that people got was around 20– 30 basis/base point slippage and the reason you haven't heard about these new products is because they have been launched a couple of months back if I'm not mistaken, we were the first ones to launch a couple months back. So, we haven't had these products in the shelf line of mutual funds for long, but I would not expect any slippage in this fund primarily because there's nothing, once you buy it, shut it, forget it, there's no investment risk, there's no market risks. I think just one clarification or qualification rather, I just add to what Rohin said that this will be efficient, how much efficient eventually ends up with assumptions of where the reinvestment could be, if yields fall, the efficiency increases but, by and large, even if the rates don’t move and rates remain where they are, and we have done this scenario analysis around a month and a half back. The fact is that even if rates remain where they are, your final, let's say your final second last coupon, will happen six months before your fund expires in a normal target maturity fund and you'll have to reinvest it in a six-month period. Now, Indian yield curve has usually been steep. This is the time when the yield curve is very flat. That means a one year is quite similar to three or four-year yields. But even today, if I look at my six months table, I think it should be going somewhere around 670 to 680 and target maturity funds that we are locking in is at around 7.5%. So even if the yield curve does not move or change, the last reinvestment risk will be are happening at 680. Similarly, a second last will be happening at seven. So, our assumption is that if the yield curve does not budge at all, at that time also the slippage should be around five basis point of course these are assumptions and if the yield curve falls then we expect by more than 10 basis points. Target security plan for the product.
Okay, well it's an NFO that ended on the 21st of Feb if I'm not wrong, so the fund will be open soon and for people who might want to consider post NFO if you are of the belief that this suits your needs then you can think of this. Sandeep, do you want to add something to it?
Sandeep Yadav: It's a closed net fund, so the NFO is done and dusted, so it is gone . Having said that we'll be launching, so we intend to launch after every two weeks these target maturity funds.
Well, viewers. That's the view from DSP now, okay, I made an error there. The NFO is over so that fund is out of the window. But there might be other funds that DSP might launch. There may be other funds that other teams might launch, and you might want to talk about those or consider those at some point of time. Okay, so that's the word on the DSP fund, Rohin, may I ask you, from your perspective, if I make a hypothesis of there being an investor who doesn't have a home loan, doesn't have other loans, and NFO is not interest at eight-nine % or what have you? Is this the kind of product that you would go for, or you'd be happy with the Target Maturity fund?
Rohin Pagdiwala: Like I said earlier, it's a marginal difference in my mind between these two products. I used to prefer target maturity funds, simply because of the flexibility that they give. We have seen this in scenarios where markets are very volatile. There are global geopolitical crises and some of these can trigger massive changes in financial markets, massive changes in the rate cycle, etc. So, the difference that I see is that the extra return that I might get in my mind is not worth the lock in that the investor has to bear for such products. So, I will still go for Target Maturity fund with G-Sec exposure and there are plenty of them in the market. There are various maturities starting from 2026, all the way to 2034. So anywhere in between 2028-29 maturity which is about five to six years horizon, those are products that are currently giving good yields, seven point five to seven point six % I would prefer those over a Strip FMP.
Got it. So, there are multiple examples out there, right. I mean, these may not be exhaustive, but are there a couple of ones that you can talk about as examples so that people know where it is that they can go in and put the money in?
Rohin Pagdiwala: There is an NFO currently from Motilal Oswal which is the Nifty G-Sec, and I am going to read this out because these names are long, there's a Motilal Oswal G-Sec Index Fund, which is the 2029 fund. So, maturing, I think it is in April-May 2029. The yield is roughly about seven point five to seven point six %. Exposure is to G-Sec security only, so it is a sovereign paper so there's no credit risk. There's another fund from Tata, which is again maturing in 2029. The reason I am constantly referring to 2028 or ‘29 is maturity because that's the fund’s current yield curve. That's the time period that looks most attractive from a return perspective. Having said that, there are investors who want a shorter horizon. There are plenty of funds available, including from Tata to Axis to Motilal and they can look at those funds as offerings depending on their investment goals. The yields will vary from probably seven point two to seven point three % all the way up to seven point seven to seven point eight %.
Okay, thanks for that. In fact, the Motilal Oswal Nifty G-Sec, May 2029 Index fund was one that we wanted to talk about, because that's also a new offering and I am sure there'll be an advertisement blitz out there. So, people would want to understand what is the nitty gritty of this, what are the kinds of returns which you already mentioned, and what are the risks involved with something like this, can you talk a bit about it?
Rohin Pagdiwala: What we have to understand is what a target maturity fund effectively offers an investor. What it is offering is a predictable return like a fixed deposit but think of it as an efficient fixed deposit. A fixed deposit tells you will get seven point five % or seven point two five %. For a fixed tenure. A Target Maturity fund is similar. It gives you an indicative yield in this case, the return is not promised, but it's almost it's very predictable, it will be in a very, very narrow range. For that yield you have to keep your money for a certain period of time, in the Motilal’s case it is up to 2029 and the yield is about seven point five to seven point six % because these funds are pegged to the G-Sec./Nifty G-Sec Index, which they invest in only government securities, which means that there is almost zero credit risk unless the government defaults, which is a scenario that we cannot even imagine. But assuming that that never happens, this is almost like a zero-risk product. I think investors can safely get exposure to it if they want to remain in the fixed income space. I think it's one of the best products and the best innovation that I have seen in the last 10-15 years in the markets and a great time to enter these products as well.
Got it. Rohin, just one quick follow up for people who are not wanting to stay till 2029 or 2027 or are undecided which is what we spoke about in the first instance, would a Target Maturity fund be a good option, or should they choose something else even if it comes at slightly lower returns. But is there a fixed income avenue available for an investor who wants to park for the long term but also wants a little bit of that flexibility without taking the risk of an MTM.
Rohin Pagdiwala: Niraj, the short answer not exactly, there will be products which you can use as open ended products for a shorter time duration. So, let's say if you have in your mind let's say two scenarios in your mind, you clear that okay, I can keep the money for three years, not keep it for five years. Then there are Target Maturity funds available for the three-year horizon. Those are the best options to take. However, if you feel that you will keep the money for five years but in the back of your mind, you might not you're not sure you might need the money in four years, then I would recommend doing multiple investments, some portion of your money in a shorter 10-year product, some portion of the money in a longer tenure product, to mix and match so that in case you need a part of the money you can withdraw from the shorter tenure product.
Okay. My final question is this talk of this IDFC U.S. bond fund of funds coming out and therefore it being an alternative for Global Investments, something like this was trying in the past a few years ago, they intended returns didn't quite come out. Have you looked at this new potential offering and what it could mean, we are a bit early in that stage in that but still, it always pays to be early as opposed to be late. So, can you tell us a bit about this?
Rohin Pagdiwala: Yes, there is an IDFC fund which I am aware of, which is investing, which is a fund of fund which intends to take exposure to U.S. Treasuries, which as we know because the interest rate increases in the U.S. have added or I won’t say all time highs but at recent height., The U.S. Treasury one year is offering about four point six % yield right now and IDFC fund intends to take exposure to that. The advantage I see, and this is this is the assumption that the INR continues to depreciate against the U.S.$ dollar which has historically typically three to four % a year, assuming the INR depreciates by another four % and then by taking exposure to such a fund I see a return of eight % plus because four point six % on the U.S. Treasury plus four % on the rupee depreciation that's an eight and a half % product. Having said that, we don't know whether the INR will depreciate, but that market is much more volatile than what I would say fixed income markets. So, I think there's a tactical opportunity, but I wouldn't go long too. I wouldn't tell too many of my long-term investors to dabble in that. The reason I said there's this one-use case which is pretty interesting is for parents who send their kids abroad, or have plans to send kids abroad in the near future, six months, six months to a year away over. They will need dollars and they have two options. I mean, and assuming they don't want to enter equity. They don't want to take the equity risk today and they want to hedge against the dollar. There are two options available: one is they can remit the money abroad and invest in U.S Treasuries or dollar funds. The other end if they don't want to do that and the opportunity that this fund gives you can remain put to keep your money in India invested domestically in the IDFC fund of funds, get an eight, eight and a half % rupee return, which effectively hedges against the dollar. So that is a use case I see for this product otherwise, it's a tactical opportunity to make eight % plus.
Last question, are there any major risks with such a product?
Rohin Pagdiwala: Yes, one is currency that I already alluded to.
Which is not a major risk, because usually the rupee has depreciated.
Rohin Pagdiwala: But it is very volatile. It is like currently the Indian rupee has depreciated recently in the last three to six months quite sharply and then for periods of time, there may be nothing that happens and then again will depreciate. So, if you catch the depreciation then it’s okay. But in a one-year window, you may not catch the depreciation to the tee. So that's one risk that I see, the other is how interest rates move in the U.S. we don't know. So, two big calls out there.