The Mutual Fund Show: Why You Should Add Debt Schemes To Your Portfolio
The returns and benefits that debt funds offer make them a lucrative addition to one's portfolio
The returns and benefits that debt funds offer make them a lucrative addition to one's portfolio, according to investment experts Amit Bivalkar and Raghav Iyengar.
Talking to BQ Prime's Niraj Shah, Bivalkar, MD and CEO, Sapient Wealth Advisors & Brokers, said that
The government of India is borrowing at 7.3–7.4% through the sovereign bond. "If you are going to get that kind of return or a YTM on debt, with indexation benefit, I think, debt definitely warrants a place in the portfolio today," he said.
Debt funds offer the same predictability and easier liquidity as compared to fixed deposits, Bivalkar said. The biggest benefit of choosing a debt mutual fund over a fixed deposit is the indexation benefit one stands to gain from the former asset class, he added.
Deferment of tax on interest accrued is another major advantage mutual funds have over other fixed-income instruments, according to Raghav Iyengar, CEO at Axis Mutual Fund.
"Unlike other fixed-income instruments where you get a regular coupon and you pay tax every time you receive that coupon, here essentially whatever returns the fund is making in the form of interest keeps getting added. So, you can keep it until you really need it."
Watch the full conversation here:
Edited excerpts from the interview:
Raghav, an average viewer will be trying to understand that if in the long-term over five years or over three years, equities return usually average out volatility and if equities give the best returns, why should one choose debt mutual funds?
Raghav Iyengar: It's a brilliant question. It is something I spent the last twenty years of my life trying to answer. I must confess in the beginning of the show that I have done a very poor job of sort of talking about or getting fixed income into investors’ mind because unlike equities where people have now got used to volatility, fixed income is also market-linked and fixed income investors are very, very worried about volatility.
Just to answer your question in a simple point, if you have a near-term expense, I mean, like four or five years away and five years is, in today's context I would call it medium-term, it's not really long term. I think, equity is now given where we are, you have to have a much longer investment time horizon if you really want to play out the volatility.
I think, fixed income, first of all, needs to be looked at from a three to five-year context and number two, as you know, basic students of economics will tell you, both asset classes tend to move quite differently and very rarely, I mean, in the last couple of years, it has happened that they have converged, but that's very, very once in a while because of Covid and stuff like that, but most of the times when equity does well, fixed income doesn't do that well, and vice versa.
So, it's like a two-wheeler, you need to have both wheels for the scooter to get going. So, in that sense, as an investor, you need both parts, you need to have the equity wheel and you need to have the fixed income wheel. It also tends to smoothen out your investment experience because of that. So typically, near-term goals, more stability to portfolio, more predictability and a very different asset class giving you a very different set of outcomes than you would expect from equities.
Amit, in your mind, does the current environment, maybe the valuations of equities or otherwise lend itself to necessarily having some bit of fixed income exposure in your portfolio, even if one is largely an equity-oriented investor?
Amit Bivalkar: I think, this question is not either-or, even if you are equity investor, you should always have a debt portfolio because in asset allocation you should have all asset classes as a mix. Your question onto valuation, a simple math there is, that if your market cap to GDP is higher than 100, then clearly over the next two-three years you get muted returns. Therefore, you need to look at debt very seriously even at this point of time.
The sovereign bond the government of India is borrowing at 7.3-7.4%. If you are going to get that kind of return or a YTM on debt, with indexation benefit, I think, debt definitely warrants a place in the portfolio today.
So, your dividend yield is 4 or 5%. If you flip the PE and compare it with the YTM and then if PE is at 14 that means the yield on the portfolio is seven, while the government offer securities at 7%. So, debt is something that you need to look at very carefully now and should warrant a place in the portfolio.
What's the best way to play this fixed income and since this is a mutual fund show, let's try and keep the bent towards how to use mutual funds to walk the talk that you are talking?
Amit Bivalkar: Typically, in debt, I would like to compare it with a fixed deposit for a particular individual and when you look at fixed deposit, we always try to look at post-tax returns which fixed deposit can offer compared to a mutual fund.
Now, mutual funds have a unique feature where you can get an indexation benefit if you stay for three years plus. The biggest benefit, according to me, is that predictability is something what you get in fixed deposits and mutual funds.
But here, if you put say Rs 5 lakh in a mutual fund and the requirements is Rs 50,000, you can always withdraw those Rs 50,000 and the Rs 4.5 lakh can stay earning the yield on the portfolio. While in a fixed deposit, if you have put in a Rs 5 lakh fixed deposit and you require Rs 50,000, you need to break the entire fixed deposit and you have a penalty interest on that.
So, predictability is one, second is liquidity and third is the biggest advantage, is the indexation what mutual funds can offer. So, those are three things one should keep in min.
Never, ever have a mismatch of duration, which means that if you require money in six months, do not put your money in a three or a five-year maturity mutual fund. If you have money for five years, do not put it in a liquid fund. So, as they do it in banks, they call it asset-liability matching. Similarly, in case of individuals, you need to do asset-liability matching, wherein your maturity and the fund’s maturity, if you can get that right, I think you can get decent returns in debt mutual funds.
Raghav, same question to you.
Raghav Iyengar: Amit has struck it completely out of the park, so it's very little I can add there. It's just that the other thing people tend to miss out on is sort of deferment of your tax on your income. Unlike other fixed income instruments where you get a regular coupon and you pay that tax every time you receive that coupon, here essentially whatever returns the fund is making in the form of interest keeps getting added to get it. So, you can keep it until you really need it. You can just keep it and you pay tax on whatever amount you take out.
So, apart from the indexation, which is a very big benefit. The deferment of your taxes is fantastic, and the flexibility is absolutely great. I think, the biggest mistake that investors have made, and I am glad people like Amit have brought it right up and centre, is that people go by past returns like every other product.
Obviously, you know, in a falling interest rate scenario, the one who has the highest duration maturity tends to look good. So, people tend to put money into that without realising that the fund is taking much longer duration and then when they get a negative return, they tend to blame the partner or the advisor or the mutual fund or whatever it is.
So, I think the biggest risk of mutual funds is to get your money duration to match to the duration of the portfolio, if you can do that. I think you are more or less sorted in life.
What's the quantum of debt mutual funds in an overall portfolio, what would you reckon is apt for people who are, let’s say, sub-30 or sub-40?
Raghav Iyengar: So, it's very need based, you can't give ‘a one size fits all’. The fashionable thing to say 60-40 debt. That's the fashionable thing you will read in lots of financial planning journals. But the fact is that if somebody's got a need, and again, I go back to my first point, somebody's got an expense in the near-term, please put all that money into fixed income. I mean, don't take a call, especially today, and try to be smart and put money into equity.
So, it could be as basic as that my daughter is going to college next year, so I would need to pay money for her graduation, maybe in April 2023 and ideally, I should be taking out money now and putting it into a fixed income fund right now. I really liked what Amit said, something with a three-six-nine-month kind of a duration, because that's exactly when I need the money and that money should be kept aside, your emergency corpus has to be kept in a debt fund. There is no way you can keep it in an equity fund because you don't know when an emergency strikes and you don't know what will happen and what's the state of equity markets at that point of time.
So, it's reasonably individualistic but anything which has near-term sort of financial requirements, please put that money into debt immediately because your returns are much more predictable and you get a smoother ride and today it's basically T+1 right, if you take your money out with a day’s notice today. So, you give me a redemption today before three, tomorrow morning if the transaction is smooth, it goes into your bank account. So, it's as good as that.
So, emergency funds, near-term expenditure, immediate expenditure, which is something coming up in the next two, three years and obviously so.
I think like a corporate in this case, corporates also do exactly this, you know they have money. For example, I have corporates, who need money in March-end to pay out maybe some royalties, that money is parked into a three-six months kind of a product. I know a corporate who pays dividend in July, so that money is parked already into a one-year product.
Amit Bivalkar: Just to add, there are a lot of our clients who do SIPs for paying the annual premium of LIC, they keep money in a money market fund through SIP and they withdraw when they want to pay the LIC premium or their car premiums or their medical insurance premiums.
So, you can use debt as an accumulator for an expense which you know is going to hit you in the next three-six-12 months. So, not only as allocation, but also for efficient use of your money, you can use debt as a product and there are options.
So, if you have a six-month view, I think, liquid funds today will be the ideal option for you to go and park your money. If you have a 12-month view and in next Diwali, you want to plan a vacation, then clearly a money market fund will suit your needs. If you have something that is coming up after three or five years, maybe a banking PSU kind of fund will help you with your goals. If you have a really long-term view then clearly there are rolled down funds which talk of 25-year, 20-year constant maturity Gilt funds. If you have that long view, then almost all these 10-year,15-year funds will give you a better post-tax return compared to anything in debt available in the market.
So, I think you need to list down what the requirement is and when the requirement is, and accordingly there is a product which is created by people like Raghav and others. You have every product which will match the duration and the requirement.
What are the risks-to-return that people would have in fixed income products as we stand currently? Amit, you are first and then I will get Raghav on this.
Amit Bivalkar: Any debt product has three main risks attached to it. One is that of the interest rate risk. Higher the duration or the maturity of the portfolio, you will see volatility because of interest rate movements, that is number one.
The second one is liquidity risk, if there is a ‘run on a fund’ and we have seen that in April 2019 with a fund house. So, if you ever have run on a fund and he is not able to sell his portfolio because it's not liquid, then you can see problems in those funds and the third one is the credit risk, wherein, where am I investing and what kind of quality companies am I lending my money to? So, if you have interest rate risk, liquidity risk and credit risk covered, you will not find any more risk into debt funds.
Debt funds are an alternative to your fixed deposits. Hence, we should not try to maximise the return out of debt funds. But you have to optimise on a post-tax basis compared to your fixed deposit and that is what people need to remember.
Most of the times people look at the rear view mirror and see that Gilt funds have delivered better returns, so let us put the money now. I think, we should not make that mistake. Look at the yields which printed on the fact sheets of every mutual fund, look at the maturity and accordingly decide your maturity and the funds maturity. That's the easiest way to do it.
Raghav, what are the risks to your mind currently from a fixed income investing perspective?
Raghav Iyengar: We have one large risk which is inflation, because inflation tends to spike interest rates up and unfortunately a lot of India's inflation is imported. So, it's very difficult to sort of pull up numbers on it and that's largely because of oil and gold.
So, any call that you take on fixed income, you have to look at oil prices, you have to look at gold prices, you have to see a bit of the external environment because we do import inflation, 80% of our consumption needs for oil comes from abroad.
As of now things seem to be quite benign, I think, the world is slowing down much faster than expected but there is obviously the risk of the U.S. doing far more rate hikes than what it is. The U.S. is the global money supplier today, so whatever the U.S. Federal Bank does, will have an impact all over the world.
My sense is in India, it would be a bit less muted, because we are largely a domestic economy even today. So, in that sense, we are in a bit of a sweet spot. I think, the pain of the fixed income has already, to some extent, passed.
We have had a crazy period over the last six months where interest rates have gone up in some categories by almost 2.5-3% and I am sure many of your viewers are seeing that on their EMIs today. I think the EMIs which used to be sub-7%, have now crossed 8% comfortably right now, in fact trending more towards 9%.
But given all this, I think, fixed income is in quite a sweet spot because our sense is that the worst is behind us and like Amit pointed out if you are getting 7.5% on a government security which is the epitome of safety in India, I think, it's too good to be true at this point of time. So, one should look at fixed income.
You remember Niraj, last year at this time, we spent a large part of our time talking about hybrid funds and they have done quite well for the investors. So, that is the reason why I am thumping the table and saying that you need to put more money into fixed income.
I think, the biggest risk for an investor is to make sure that he is matching his or her investment horizon with the duration of the fund. That is very critical, don't get carried away by past performance. Right now, I think, people are getting carried away negatively because past performance is quite bad. If you look at any spreadsheet, returns are 2-3-4%, people say I get much better returns in other things. But that is backward looking. I think, you have to take a forward-looking view. My sense is smart investors have already started coming in the last couple of months. We have seen a lot of fresh inflows starting to come in and thanks to things like your show, hopefully more people will come.
Amit Bivalkar: One point what I would like to add is, not only crude and gold, but today you look at any person, like if we look at you, Raghav and me, whatever we are wearing are all international brands which are actually imported.
Nothing is made in India. iPhone or maybe it's a tie or it's your spectacles or whatever and every time we see that consumption moving up in India, forget about crude and gold, we are actually getting dollars to go out of the country for importing these goods.
The more and more consumption goes up, you will see more and more imports which will have inflation in India, and which will put pressure on your interest rates. So therefore, it is very critical to have a look at that as well.
Raghav, multiple fund houses are offering almost synonymous products. How do you differentiate? How does an investor choose which fund house to buy into?
Raghav Bivalkar: I am personally quite lucky because I work for Axis, so there is an Axis Bank branch behind me which is very well known in the investment or in the investing community or in the community at large, I am lucky to have that because people naturally gravitate to things that they trust, and I think Axis is a very trusted brand, especially because it's a bank. So, it is an extremely visible financial institution, that is an inherent advantage that I have.
I think, you have to look at consistency of performance over a period of time. It is very easy for anybody to make money, when interest rates actually coming down, you just pick the highest duration that the scheme can get into and get there. But the interesting times is to try and figure out how the fund does when actually things start going backwards, in that space Axis has done well.
We have a short-term bond fund, we have a banking PSU fund which are pretty much leaders in terms of protecting returns. Like Amit said, this is not a game of where you are trying to hit every ball for a six. I think, the fixed income game is a lot about singles, and you'll keep making a little more money because of the indexation benefit and because of the subdued taxation. That is what gives you a delta in post-tax performance over many other fixed income instruments.
So, since we have got that advantage, then I think, one should not be very adventurous on the other side. So, many people ask me ‘do I buy credit risk short-term fund?’ Frankly, I don't think so. Credit risk fund is a great place to be, provided you understand what you are buying.
Earlier people used to have this standard formula YTM minus expenses, I think, that is not the right way to look at it. I think, you need to understand the portfolio more, ask a few more questions because you are effectively lending money to those people.
So, if you are confused about it, give money to a high-quality fund, banking PSU, short-term space and just let the fund manager and your advisor, your distributor do their jobs.
Amit, how do you pick up your fund house because the products are synonymous so to say?
Amit Bivalkar: I think one important factor is- is the fund true to the label? what they are actually saying and are they following that? SEBI has put out a nice categorisation of debt funds when it comes to credit risk and when it comes to duration. I think, that is pretty clear in terms of high credit or low credit and maturity, high maturity or low maturity.
Every fund house publishes that in their fact sheet. If you want clearly high credit funds, and if you want a low maturity, you can easily pick one from all the fund houses which are available today. It is a very easy exercise, but more importantly as I said, debt is not a place to maximise your return, debt is more as providing a safety net to your portfolio.
An important aspect is that many people need a monthly income or a quarterly income or a yearly income. The biggest advantage here is that when you redeem the appreciation in a debt fund, it gets taxed on ‘first in-first out’ basis. So, when you redeem, suppose you have invested Rs 100 and the fund has delivered 8% in a year as an example, and you redeem Rs 8, then you are charged income tax according to 'first in–first out' basis, if you effectively calculate the income tax on that, that works out to 3-4% only.
So, if you do a SWP in a debt fund, say 5%, and you put money in a short-term fund for 10 years, and you do a 5% SWP, your tax incidence on that 5% is only 2-3% and not 30% as you do. So, debt fund has this unique feature of taxation on withdrawals. I think, that is something which people have not explored.
SIP has become more like a roadside product where everybody's talking about SIP, I think for SWP there is a lot of work for the industry to do because there are a lot of elders and a lot of people who require money monthly. Choosing the right product and doing the right amount of SWP, taxation-wise, also helps you in the long run.
What is the best way or what is the best product within the mutual fund space to invest into for an emergency fund knowing fully well, that I don't know when will I need the money? Amit, to you first.
Amit Bivalkar: Predicting rain is not important Niraj, carrying an umbrella is, so that is what debt funds do. So, if you have any money which is more than one month, then you need to put it in a money market fund. If you have money which is less than one month requirement, you need to go straight into liquid funds. Why money market fund? Because you have currently at 6-6.5% YTM.
But it is only an emergency, I don't know whether I need it in one month or not.
Amit Bivalkar: If you need that kind of money, there in your bank because you can have a credit card which you can use for one month as a roller and then use this money. So that kind of money, I mean, you will not put Rs 50 lakhs in emergency fund right, you will probably put Rs 2 lakh, Rs 5 lakh or six months of your salary, something which is your emergency fund.
Therefore, any money which is 1-3 months plus should go in money market, otherwise you stay in a liquid fund, and that money can stay there forever.
As your salary grows, your corpus grows, remember, the percentile should go up otherwise your corpus might be Rs 5 crore and you will be at Rs 1 lakh in the emergency fund, that is not right.
Raghav, what is your answer?
Raghav Iyengar: Just keep topping up your emergency corpus. I think, many people discovered that to their disadvantage during the Covid time because I think they got into the habit, but they didn't top up. That is why watching your show is important because that five minute is a good takeaway. So, if you can do that, nothing like it.
Personally, I have a little bit of money of my emergency fund in banking PSU fund. That is because I have three to six-month liquidity. So, anything beyond six months, I keep about 12 months of emergency cash flow out because of my personal issues.
So, the first six months are like Amit said in a money market fund, but the remaining six months is actually in a banking PSU kind of fund for a short term.