The Mutual Fund Show: Should Investors Consider Liquid Funds Or Target Maturity Funds As Rates Rise?

Sunil Subramaniam: We tend to look at RBI’s thing from a narrow perspective of inflation versus growth. But it's important to bear in mind that RBI wears three hats. There's a monetary policy hat, there is an interest rate hat which I slightly differentiate from the liquidity aspect, and then there is a currency management hat. Overlaying all of this is the fact that they are the manager of the government's debt book. So, they have multiple things to cater to.

The second thing is that we tend to equate RBI policy to U.S. Fed policy. RBI as a central banker and the Fed as a central banker. We tend to think that the Fed's actions should be mimicked by the RBI and we tend to wear the same lens.

But there are two vital differences. The first difference is that advanced countries are demand-led economies where rates and liquidity directly transmit to the retail consumer and cause inflation or bring down inflation directly, whereas India is a supply-driven economy. In a supply driven economy, interest rate policy has limited role to play because the supply can affect interest rates on the borrowing by corporates, but not so much by the consumer at the ground end, because anyway demand is also not the key.

So, the ability of interest rate policy to impact the GDP and inflation is one. The second thing is the quantum of imported inflation in a country like India, which again is outside the purview of an RBI policy. No amount of policy interaction or intervention can do anything about oil being imported, food being imported and the third and most important thing here is that the Fed doesn't bother about currency. So, RBI has to keep an eye on managing volatility in the country. They don't target a currency rate managing volatility.

So, if you look at it within the context of what the RBI did today was a very good policy, very pragmatic in the sense that they know that 50 bps frontloading of the hike–it's actually a 90 bps hike if you take between the last policy and this. So, the frontloading basically is to give them the room to boost growth when the supply side eases. So that's why they frontload and (are) not reacting. Why the Fed hesitates to frontload is that frontload directly hits demand growth, whereas in India, it doesn't. So, there's no downside to frontloading. It's only a sentimental thing. It's a visual thing that I am frontloading a hike.

But at the ground level, if housing loan rates go up by 1%–from the average at 6.5% levels they were pre these hikes–to 7.5%. What is the impact on the EMI for a customer? It's probably Rs 100-200 per month on a 25-30 year loan. So, the RBI policy has more of a signaling effect, rather than an actual reality, ground-level effect.

And by signaling an early frontloading, and perhaps another 40-50 basis points hike also because they projected inflation at 6.7%, which is way above their thing, but they left a small window for the last quarter of the year where they showed it coming below 6%.

So, there is a hint in the policy that if the monsoon is normal, and we see food inflation–which is 45% of our CPI basket–coming down, then RBI retains the desire to retain rates there or maybe even cut rates to support growth in the last quarter of the year. It is hidden within the language. But the way I see it is that's why he broke up the four quarters.

To me, it is very pragmatic in a country like India to frontload because the Fed frontloads; it is hurting where it hurts the most, hitting almost below the belt because directly consumers get affected.

So, RBI laid off on the liquidity front. They talked about reducing accommodation over a multi-year timeframe. So, liquidity is also something that RBI eschewed a strong action today.

Sunil Subramaniam: I am not at all denying that. The fact that RBI’s actions and commentary will lead to a rise in interest rate, I am not questioning. But I am just saying that the rise in interest rate in India which is frontloading is not going to affect Indian growth so much.

Second is also anchoring inflation expectation; it's not anchoring inflation. There is a subtlety to that language, because they are going by consumer expectation of inflation. They are doing a poll. RBI is reacting to already happening inflation for the last month, but also what consumers say they expect. So, by hiking rates, they are talking about managing the expectations of people. There is a point to be noted on the language, on the word “expectation”.

Sunil Subramaniam: There are two things–the time frame outlook of the investor for the debt allocations. I will put it as less than three years and more than three years purely because of the taxation. It's driven by that.

For a more than three-year investor, they should invest only in liquid schemes. In a rising interest rate scenario, your reinvestment of the liquid corpus of the mutual funds every 30-45-60 days will ultimately lead to them participating in the accrual over a three-year time frame, whereas putting it into a medium-term fund would mean taking mark-to-market losses.

So, a three-year investment in a liquid fund today would give a better return than an investment in a medium-term bond fund because a medium-term bond fund will buy three year papers today, which will be hurt from a mark-to-market.

So, three years plus investors should stick to the short term because the fund manager can redeploy at rising, and he will make the best post-tax yield for the three-year outlook.

If you have less than three years, then I suggest an alternative product, which is named equity but is debt, and that fund name is Equity Savings Fund. It is a category which offers an equity taxation because they use arbitrage as the balancing factor.

They keep about 30% in equity and 30% in debt and most equity savings funds tend to keep shorter maturity debt, thereby getting that accrual benefit on the debt side. Arbitrage should come to the aid, both in terms of taxation as well as in terms of a volatile time when arbitrage tends to give a little bit of a better return.

The 30% equity component is generally Multicap Flexicap. In a volatile time frame, you can’t say that allocation to equity will also aid. The past track record of equity savings funds gives high single-digit return when you hold for a longer period.

The reason I suggest this is if any of the scenarios that I said played out–that we have a very good monsoon, surplus food, inflation comes down–you might want to switch back to the equity then from an equity savings fund. If you are going to do that after one year, you are only suffering 10% long term capital gains, and if you are doing it in nine months, you are suffering only 15% LTCG.

Whereas if you make an allocation to a debt fund and you want to change six months later into equity, you are going to take short-term capital gains on debt which is very painful and severe.

Sunil Subramaniam: The equity savings category, if you see most of the offer documents, does have the flexibility to take the equity down to very low levels and substitute it with arbitrage.

I would also say Dynamic Asset Allocation Funds are powerful, but fund managers are always looking for an excuse to increase equity or reduce equity. They are not anchored towards the safety element, but are looking at it as an opportunistic element, whereas equity savings by the name “savings” in it is anchored around giving a reasonable return.

There is an ability to take down the equity even to 5% or 10% if need be, if the situation pans out in that way. That's where the flexibility comes in because he can put 50% in arbitrage and only 10% or 15% in equity to get that 65% equity component.

Sunil Subramaniam: Pure equity investor should allocate 70% to Dynamic Asset Allocation funds and 30% to Flexicap funds.

Sunil Subramaniam: It depends on if you want to put people on an aggressive, moderate, conservative space. The “moderate” and “conservative”, I would say, do this. But, for an “aggressive” investor, he can as long as he's willing to wait out the volatility period—which an aggressive investor should be doing, he should be prepared for short term periods of losses. Then I don't need to change his allocation.

Since most investors are not aggressive, I recommended this 70%-30% but if somebody's already 100% Flexicap because he's aggressive mentally, he can continue.

If you see dynamic asset allocation, they are all also Multicap Flexicap in the equity part.

The volatility that we are going to see is essentially going to be FPI-driven, international news driven.

Why I recommend it for an equity investor is that recovery is ultimately going to happen. Recovery will happen on a broader cap space, because it's domestic sensitive. So, Flexicap is a better option because the fund manager can flip between large, mid and small as the situation pans out.

Amol Joshi: While making the portfolio at the design stage itself, we do take care of various aspects, including credit quality, the investment horizon, and we match things according to that.

But still, if I were to suggest fresh debt fund investments for fresh money that you want to allocate towards debt, my preference would be towards the roll-down funds.

We also now have target maturity in target date index funds, but roll-down funds is something that I feel is better or most suitable. You have roll-down funds from six months, from one-year level, going all the way to 10 or even 20 years.

Roll-down funds are funds that invest into a typical maturity, let's say, a five-year roll-down fund will invest in debt papers that mature five years from now. Irrespective of where the rates go, in the intervening period, rates might go up by 150 basis points and market cycle may turn after two-three years, and then rates may come down again. But this fund generates the coupon on the existing five-year debt paper that they have invested into.

Now, as a fresh money, you have advantage over the last several weeks or maybe a couple of months inflation as well as expectations towards a rate hike building up in the market. And the rates and the yields have already hardened.

For a five-year to six-year highest credit or even SDL kind of a credit quality, you have yield of anywhere between 7.50% to 7.7%-7.8%. That is an extremely attractive yield, and new money–if you have a horizon of four to five years–should go into funds like this.

Amol Joshi: Sunil’s point is valid because a few years back we had done this study. I am talking about 2017-18, and during that period, if you check, 10-year debt fund returns across categories–you could take liquid, corporate bond, dynamic bond, barring some of the credit funds–in most of the funds, the median, 10-year return was around 7%. Now, 7% liquid, I am talking about several years back.

However, at this stage today, I slightly differ. It is true that as the rates go up, liquid papers as they mature, those funds will be deployed in a higher yield, higher coupon papers. But I want investors to have a better outlook or better visibility of the returns that they are likely to generate and roll-down funds offer you that.

So, for three years and more horizon, I would certainly not go with liquid funds. I would rather go with a roll-down fund with a three-to-four-year maturity or I could go to a roll-down fund that has one-year roll-down cycle, in which anyway you will get a benefit as good as liquid funds, but the yields will be slightly higher, because liquid funds are constrained with the kind of maturity that they are invested into and several other factors.

Amol Joshi: You said it. Here, debt and equity are not really comparable, and we always avoid comparing them. But now that we are talking about mindset, let me get equity into perspective.

During the bull market, everybody says that ‘I have a long-term investment horizon’. But when you see a 10-12-15% hit on your portfolio, suddenly the doubts creep in. That is the time when you have to tell yourself that over a medium-to-long period, equities have delivered inflation beating returns.

Exactly, the same mindset you should have here as well. In case, the interest rate hardens very quickly in the next one or two quarters, you would have the mark-to-market impact on your NAVs of a four-year, five-year duration fund. But, you should also remember that six months hence, the four-year duration fund has reduced to three-and-a-half years. So, as the time goes by, the interest rate sensitivity goes down.

That reduces the volatility, point number one. Point number two, no matter where the interest rates go, you still get the coupon. Most of the roll-down funds invest into highest rated, triple AAA rated or even sovereign-rated debt securities. No matter where interest rates go, you will still get the coupon.

Number three, which is again very important, especially since you mentioned a four-year fund. As you know, long-term capital gain is preferred compared to short-term capital gain.

In equity, it kicks in one year later, within the one-year holding period. But in debt, it kicks in only after three years. So, frequent churning does not really help. Whatever return you have made for less than three-year period will get added to your income and it will get taxed at your marginal tax slab rate. You will lose the indexation benefit.

Since you are anyway not going to lose, even if the rate is hardened because of the Target Maturity Funds or the roll-down fund structure, you better stay put and stay for tax efficiency, as well as the returns that you started the expectation with.

Amol Joshi: There is a document called the Fact Sheet. Fact Sheet is the complete anatomy or structure or blueprint of any and every mutual fund scheme in India. The Fact Sheet is declared or published openly in a PDF format by every fund house every month. It is a regulatory requirement.

You have to go to the Fact Sheet of the respective fund house. Within that, go to the debt section and under debt section, you will be able to see several files–right from liquid funds all the way to dynamic bonds, which are typically a higher duration or even a 10-year G-Sec fund. As the name suggests, it's a 10-year duration fund. So, from 90 days to 10 years, you will get the entire information in the Fact Sheet of the fund house. And you will have to take that effort to zero down on a suitable scheme for your investments.

Amol Joshi: I mentioned in the beginning that a five year or five-and-a-half-year duration scheme currently has a YTM of 7.5% or more 7.7-7.8%.

The scheme that I had in mind was Nippon India Dynamic Bond. This scheme invests into state development loans, which you can treat as a highest credit quality, quasi-sovereign kind of paper. It currently has a five, five-and-a-half years modified duration. If you have a four-to-five-year kind of investment horizon, you can look at this scheme.

You also have a few other roll-down schemes. I will talk about a scheme managed by IDFC which again completely invests into 100% AAA rated maturity segment. IDFC Corporate Bond Fund is another scheme that you can look at.

Amol Joshi: Why reinvent the wheel? Even if you have a less than three years investment horizon, you can go with a scheme that has only one-and-a-half-year modified duration.

Let me give out one such option–the Nippon India Floating Rate Fund currently has a modified duration of between one to one-and-a-half years.

Within one, one-and-a-half years, the fund will roll down–all the debt papers, existing debt papers will mature. It is not on the higher side and despite having a one-and-a-half-year, which is a comparatively shorter investment horizon, you will still not get volatility, even if the rates harden from here because of the roll-down structure of the fund.