The Mutual Fund Show: The Options Fixed Income Investors Have As Rates Rise

Raghav Iyengar: If you go back in time, we had the Covid crisis, which now seems to be like something that happened in the previous century. We sort of quickly overcame that and we are back to normal. But thanks to Covid, I think one big response which happened overall in the financial system was central banks pumped in a lot of liquidity into the system.

That had a bit of a fall in interest rates, and this was very good for businesses, very good for small business owners, people paying loans, etc. But that led to interest rates really coming down. In many points of time, much lower than the rate of inflation.

Especially in the last 18 months, I think most governments and central banks have realized that inflation is now a seriously worrying issue and one way to fight inflation is to obviously raise interest rates.

Like everywhere else in the world, our Reserve Bank has also raised interest rates substantially, especially over the last 12-13 months. So, now what we got real rates, which is essentially the rate of interest minus your approximate inflation rate, is actually positive today.

So, even a basic fund like liquid fund today can give you a YTM of close to 7%. Just to give you the year back scenario was possibly less than 5%. So, you can see just in a year, it's gone up 2%. So, the challenge for us in industry is that when interest rates go up, you know, prices come down. So, obviously there is a what we call a negative mark-to-market in that.

So, obviously when people look at their fixed income instruments, they don't see the rates going up. They actually see the prices coming down, because that happens first.

But anyone who's putting money in now is actually getting in at a much better portfolio yield than what he was getting maybe a year, year and a half back and that's the exciting opportunity today.

Mrin Agarwal: I think we are towards the peak of the interest rate cycle and I do see a lot of investors still waiting for rate hikes and while we might have one or two more rate hikes, I think it's really difficult to just keep waiting for that right number and it's a good time to make an entry because you do have various investments available on the debt side.

You have actively managed funds, you have passively managed funds, and you are also getting very good yields at this point in time. So, I think, you know, the first thing is, of course, whenever you are constructing any portfolio, it's about what is your goal, which means what is your holding period and secondly, what is the sort of risk that you are willing to take and then you have a whole variety of options that are actually available today in the fixed income space.

Mrin Agarwal: Yes, I also agree that it should be a blend of both, for various reasons. So, actively managed debt funds have always been there, where you have a fund manager who's taking calls based on the interest rate scenario and takes calls based on credit risk in various companies and constructing a portfolio.

Now you have passively managed debt funds. So, what this means is that, like in the case of equities, where the fund manager would mirror a particular index, here too a fund manager would mirror an index, but this would be a debt index.

There are different types of passive debt funds that are available. So, for example, you have the most popular one which is the target maturity funds that are there, you also have gilt and liquid passive debt funds available.

Now, what happens in the target maturity fund is that there is a target date. So, while the scheme is open ended, and you can exit the scheme whenever you want to, of course, at the current valuation, but there is a target date on which the scheme is going to end and by investing into a target maturity fund, your predictability of returns is much higher because it's ‘hold to maturity strategy’ where the fund manager buys the bonds and holds them to maturity. So, you are fairly clear about the sort of returns you're going to generate out of this investment. So, these are the basic two things that are there.

The advantage of the passive fund is of course low cost, they are fairly liquid, you can still exit in between, but I think, when you are actually constructing your portfolio, it helps to be very clear about what is your holding period, and if you are absolutely clear about it, you don't want to take any risk.

You find it difficult to figure out what else fund to get into, then passive debt funds are the funds for you, but do remember that in active funds, fund managers can take some calls, which can help improve the performance of the portfolio as well. So, I would say go with a combination of active and passive debt funds.

Raghav Iyengar: Passives are a very recent addition. I mean, in the sense that they didn't exist in a meaningful manner till maybe just 12-14 months back. So, we have seen in the last 6-8 months, a lot of money moving in the industry, to passives.

Like Mrin mentioned, I think the biggest advantage in a passive fund is your predictability of portfolio because you are essentially buying the index so you can't buy anything else apart from that and you have a predictability on your end date.

These instruments were earlier called fixed maturity funds, if you remember not too long ago, but FMPs had one big disadvantage is that they were essentially illiquid, when you can trade it in the stock exchange, but there's hardly any liquidity. So, if I needed to get out of an FMP in the middle of my investment journey, for whatever reason, it would be very difficult to do so.

So, the advantage of being actively managed is it's a very old asset class, for example, our biggest actively managed fund is Axis short term bond fund, but it's got like an eight year plus investment history. So, you can actually see what the fund manager has done at various points of time and draw your conclusions from that.

But yes, like it is an open-ended fund, so, if you are not very clear as to when you want to get out of that fund, you are not very sure, but you are just doing it from an asset allocation perspective, which is to my mind, a very important component of your portfolio.

If you're going to say I am going to have, say 30% in debt, but you don't know when you need that, I think it's better to go for an actively managed fund, because the big disadvantage in passives is that it gets over. So, you are exposing yourself to the biggest risk, which is reinvestment risk.

Today, let's say we have an Axis SDL fund, as of yesterday evening on the website, my YTM was close to 760. But I don't know in 2027 what's going to be the portfolio yield or what's going to be the market at that point of time.

Whereas an actively managed fund manager will do certain things to make sure that your portfolio is being optimised. So, I think like Mrin exactly said, you can't have an odd strategy, you have to have both parts in your portfolio, and that's really very individual.

So, if you have a need in the next 3-5 years, then you can time that and you can marry that to a target maturity fund, that's fantastic. But if you don't have something, you are just investing from an asset allocation perspective. Maybe better to stay with open-ended actively managed funds.

Raghav Iyengar: I think that you can do it in both. So, because obviously if you have a view that you're going to make a lot of money on capital gains, you feel that interest rates have peaked out and you obviously try and get into the longest duration fund possible and there are funds, like you know, we have approval to launch the 2032 passively managed G-sec fund, that's like practically 9 or 10 years of maturity. So, you can do it like that.

The other way is of course, you play a normal open-ended fund, and you again have a track record of what the fund manager has done at various peaks and troughs of the interest rate cycle. My belief is unfortunately a bit different. I think fixed income is also an equity type asset class. You have to fill it up, shut it and forget it. For the simple reason is that I think tax laws in mutual funds are very, very conducive to creating wealth through fixed income.

I mean, you don't pay any income tax till you actually take out the money. When you do pay taxes, it’s actually on a higher principal amount because you get the benefit of what we call indexation and of course, the longer you keep it, the greater number of indexations you get. So, I have had investors who kept money for 8-10-11-12 years and fortunately I made good money on a CAGR basis. Pretty much similar to what some of our balanced funds have made and at the same time, not really pay too much tax also.

So, I think this is a misnomer in people's mind that fixed income is for three months, six months, one year, yes, it is for those things, but you can actually keep it for very long duration. But coming back to your point, yes, I mean, if you are a believer in peak interest rates, which is a very debatable topic today, news channels are full of it, but I agree with you.

If we are somewhere close to the top, I don't know whether there's another 25 or 50 coming, it will be led by what is happening internationally. But I think India frankly, we have done a much better job in managing inflation than many other parts of the world. I think possibly because of that maybe the rate cycle is pretty much close to the top. So yes, that's it. Yes, you should put money into a long duration fund and ride in capital gains all the way down.

Raghav Iyengar: I think Mrin is brilliant for these things because she actually talks to live investors. I talk to you and to her actually more of the time but yes, you are right. I think the fact is that you would like to save, you can do both, you can do the 2032.

The reason as to why somebody should take a longer duration asset is not obviously capital gains, is a bit of a pitch in the dark, because you are trying to guess estimate interest rate cycle, which frankly is very difficult to do. It's like predicting the Sensex.

But I would go for a long duration fund more from a longer-term need perspective that I can get maybe for a 10-year asset today if I get close to 8%. I think that's a great yield to lock in your money and I will keep that money for 10 years because I don't know if I am reducing my reinvestment risk by that much at that point.

Mrin Agarwal: I think I would also kind of agree with Raghav, that I would try to lock in into long duration debt funds right now because you are getting good interest rates, you are getting good yields. So, let's say that you go in for a three-year target maturity fund, you do face a reinvestment risk at the end of three years, and we don't know what interest rates are going to look like.

Typically, when I look in the past also, you know, when I looked at the highest tax-free bonds that came, way back I think in 2010, the return was 8% tax-free and with some of these passive funds, you are actually getting, not 8%, but maybe slightly lower, but still very good rates on a post-tax basis. So, I think it really makes sense to lock in for as long as you can, of course based on your goal.

Laddering is an approach that has been used and the advantage of laddering is that you make investments which are maturing at different points in time. So that allows you to have maturities every year which then you can redeploy, and that somewhere does sometimes take care of the reinvestment risk and the interest rate risk.

But honestly, I believe that when you are constructing a portfolio, it really has to be based on what is your holding period which is based on your financial goals, and that in itself will help you create a laddering portfolio.

Mrin Agarwal: Yes, you can always have that. I mean, you can always keep some amount of money in ultra-short duration funds or low duration funds for this particular purpose.

But to be honest, I also believe that there is ability to create alpha even in debt portfolios by taking some tactical calls and while debt investments are done for conservation of capital, I don't think that one should just go for the safest instrument that's available.

I mean, certainly there are opportunities within the debt space as well that can be looked at. And again, I am not talking about lower credit risk options, I am talking about good credit risk options itself, that can be considered.

For example, you know, maybe like one of the tactical allocations since you were talking about it, is to look at investing into gilt funds at higher interest rate or at higher yields.

Raghav Iyengar: Actually, that's the proverbial pot of gold because bank fixed deposits are many times the size of retail debt assets, if I can use that term. And I have seen in my career that whenever interest rates start trending close to 8% on traditional instruments, obviously, there is a flight of money that goes out into those instruments, which obviously I think what an investor is looking for in fixed income is predictability, and traditional instruments offer the best predictability today.

So, I think there's a bit of a swing and we saw a swing out about two years back, but thanks to Covid and thanks for liquidity, rates came down dramatically and they were much lower than they are today. So that little bit of swing is going back.

But as far as the second part is concerned, I think communication is now the other 25 years. I think bond funds have been in existence now for 24-25 years, so, we have seen the kind of value that they have delivered over a 20-year period. So, like we talked about equity funds for 20 years and this made so much wealth for you, you do have a number of bond funds and that number is quite attractive, like Mrin pointed out.

It is fairly similar to what you would have made in a tax-free bond had you invested 10-15 years back in the highest tax-free bond. The other thing I think people are trying to understand now very clearly is that this is a great way to defer your tax because you don't need to pay tax on your mutual fund investments debt side as long as you don't take it off plus you have the flexibility.

I mean, if you have a Rs 1 lakh, you need only Rs 5000, you take out the Rs 5000, you pay the money on the Rs 5000. So, these are some three-four things that we are trying to say which are a bit distinct. But today, yes, there is an outflow of money and that's typically fine. I mean, that's okay, because as long as money is in the financial system, it's okay. I think someday it will chase the best quality service provider for it.

Mrin Agarwal: Yes, ideally. I think if you are getting into a target maturity fund, it should be a clear ‘hold to maturity’ strategy. The point to keep in mind is that you can exit in the interim, but you will see the NAV volatility.

The second thing is also that sometimes the secondary market liquidity in specific funds could be low. So, maybe there could be a lack of trades and stuff like that. So, that's the other aspect that one has to keep in mind. And while right now we are seeing this rising interest rate scenario, if things were the other way around that, you may not want to be in a target maturity fund.

So, I think right now it's good to look at it but be very clear about your holding period and be clear that you can hold it, like think of it like how you did a tax-free bond is what I would say. As long as you are clear about your holding period and willing to hold on, I think it works for you. But if you are not sure of your holding period, looking at something which is more liquid, then I think you should certainly look at the actively managed debt funds.