The Mutual Fund Show: How To Build A Debt Portfolio Amid Interest Rate Volatility
Rising rates work in two ways. Fixed-deposit investors get higher returns but borrowers of car and housing loans pay more.
Changes in rates, and as a result liquidity, influences prices of stocks, real estate, cryptocurrencies and commodities. And that warrants repositioning of fixed-income portfolios. One way to protect portfolios is through diversification.
Short-term rates have risen more than long-term rates in the past three months, Sandeep Bagla, chief executive officer at Trust Mutual Fund, said on BloombergQuint's The Mutual Fund Show. Since interest-rate fluctuation majorly affects retail investors, he advises dividing the fixed income component of the portfolio into a mix of corporate funds, long-term bond funds, banking and public sector unit debt funds, short-term funds and money-market funds.
Kirtan Shah, co-founder and chief executive officer at SRE Wealth, agrees. If an investor has long-term exposure and the fixed income portfolio is not maturing in the next six to 12 months, he suggests avoiding major changes as the situation could change in 24-36 months.
The difference caused due to taxation could have a high impact as an investor would not get the benefit of indexation, he said.
Watch the full conversation here:
Here are the edited excerpts of the interview:
If the hypothesis is that rates are on the way higher, how should an investor alter their debt investment strategy?
SANDEEP BAGLA: When we say rates are on the way higher, it could mean that one part of the yield curve would go higher than others. If yields go up, interest rates go up, and bond prices fall, thereby impacting adversely the investor’s return in the mutual fund scheme. So, it’s quite possible that the shorter end of the yield curve goes up faster than the longer end, but it is (also) likely that the entire curve will rise. So, whichever path you are on, you are likely to experience slightly lower returns.
Typically, as per the hypothesis, you will go into liquid funds so that there is no impact. But the problem is that in liquid funds, you get only between 3-3.5% returns. If you were to increase your duration by another two years, let's say go into two-two and a half years maturity kind of bond or “rolled out structures”. For example, a corporate bond fund has a 2.5 year maturity, which is yielding 5.5%; and a banking and PSU Debt Fund is giving 5.5% for 2.5 year maturity. You will get substantially higher returns than liquid funds, almost 2.5% higher.
Since the investments will roll down, which means the maturity will keep coming down with time, the interest rate risk will not be very high. So, even if interest rates go up, funds will not be impacted. The idea is basically to not earn great returns. One cannot expect great returns when interest rates are going up.
Markets are on the verge of repricing themselves. So, just like equity markets are repricing from a situation; they are rebuilding in probabilities of growth and very easy monetary policy all over the world. Even bond markets are repricing inverse rate where you expect higher inflation and higher rates. So, it’s difficult to see which part of the curve will do better. But the roll-down maturity funds, up to two to three years, and money market funds should be alright.
What would happen typically to an average investor if they are holding current funds? And if rates were to go up, how do the NAVs get impacted? I am presuming they are impacted negatively. What’s the result and impact and how much deviation does it come to? Is there a way to explain that?
KIRTAN SHAH: Typically, what happens is when the yields go up, you would see that the NAVs of the bond funds would fall.
The logical explanation to this is by using an analogy. Let’s say today, if you want to invest in a fixed deposit, which pays you 5 %, you invest and lock yourself in for three years.
Let’s say, the rates go up tomorrow. The same fixed deposit pays you 5.5%, or 6% or 6.5% because the rates have gone up. You are still locked in for 5% for three years. While everybody else in the market, on the same risk product, is going to make 5.5%, 6% and 6.5% because rates have gone up and you are still making 5%. So, the product that you hold will fall in value. That is exactly what happens when rates go up. So, when rates go up to 5.5%, 6% and 6.5%, and if you are still holding the 5% product, the value of the 5% product drops. Hence, it is said that when interest rates go up, bonds or mutual funds are negatively impacted.
Let’s look at two examples. I have a fixed deposit for six months and another one for five years. Now, what will get impacted?
The answer to this is simple. If I have a six-month fixed deposit, which I hold for 5%, hypothetically, my maturity is going to be at the end of the sixth month. I can reinvest it at a higher rate which prevails in the market, and hence the loss of opportunity for me is only for six months. When rates go up, this product, which is going to get redeployed again, will fall slightly less because the maturity is close by. You will be able to redeploy it at a higher rate.
But the five-year fixed deposit would probably react more on the downside because you have locked yourself in for a longer period. And you are not going to be able to reinvest the principal (amount) any time soon.
And hence the rise in interest rate will impact the five-year fixed deposit more than the rise will impact the six-month fixed deposit.
I don’t want to get into the technicalities of how a modified duration will come into the picture with rising rates. But largely, this is how it impacts. When interest rates go up or let’s say yields go up like the markets say, the product which has lower average maturity or modified duration would react less on the negative side. And the product which has higher average maturity or modified duration will react more.
SANDEEP BAGLA: That if interest rates go up, another way of looking at it is that if you were to lock into something (at a certain) interest rate today, and if interest rates were to go up tomorrow morning, it is the opportunity cost that you have lost of investing tomorrow. If you invest in an FD at 5% today, and tomorrow, for whatever reason, the rates go up to 7%, then you have lost that opportunity of investment at 7%.
From the perspective of an investor who currently has debt mutual fund products across various maturities. What does an investor do with the current investments if they believe that rates are on their way up?
SANDEEP BAGLA: A couple of things have become popular in the past. I have seen bond funds having rolled down maturities of 10 years, seven years or five years that have become quite popular.
In our markets now, the cycles are becoming far shorter than what they used to be. You will probably see, in five years, very low interest rates, as well as very high interest rates. I hope not but it is quite possible. It has happened in the past.
At a time when you know one or two or three quarters, locking in your strength with the objective that you are going to invest for 10 years is perhaps a stretch because you might need the money in less than 10 years. At that point, interest rates might have risen and your mark-to-market would not be favourable. If you are trying to match the requirements of your money and the fund that you are invested in, which is fine, then do it wisely and you should not think of taking all the money before. So, that was one point that does not go into rolled down schemes (of) more than three years, because in three years, even if interest rates go up in one year, because the maturity has come down to two years, the interest rate impact will be less. Hence, your net asset value is not likely to change much.
Most of the money that I see today in mutual fund schemes has rolled down to, has moved to below three years. Most of the money is not lying-in long term G-Sec (government securities) or long-term income funds, any other asset category which is floating rate kind of a bond fund.
The floating rate bond fund typically suggests that if interest rates go up, they should benefit, which is hardly the case. It never really happens. The investors get logged into a spread in a bond which can increase and has the same impact, as interest rates going up.
The best floating rate fund is the liquid fund, which rolls up when interest rates go up and keeps going up. So, the funds to avoid is credit funds, floater funds and long-term roll-on funds.
Kirtan, here is an investor who is listening to us, and she wants to know what does she do with her existing investments? Which are in debt products? The maturity is maybe slightly far out, maybe slightly near as well. What does she do, if the hypothesis is that the rates are high?
KIRTAN SHAH: Investors, unless their goal is close by, should not do anything. I am of the firm belief that in the retail investor category, I don’t see a reason why most investors will be able to time equities and more precisely debt funds. So, if your goals are not nearby, don’t do anything.
In a lot of these funds, unlike equity, liquidity has always been a problem. When rates are moving up because of whatever has been happening in India or globally, that MTM impact has already been accounted for in the near term in the fund. Now if you were to get out of it, you are actually booking the notional MTM loss and making it a permanent loss for us. Also debt in the debt category taxation is an extremely important data point that you should definitely consider, because if your investment is anything less than three years versus more than three years, the differential tax is extremely high.
So, if I am in a 30% tax bracket, I will end up paying 30% if my investment is less than three years. And if I stay invested for more than three years, the indexation code helped me save 50% of my tax outgo. So, in my opinion, timing in the debt market is even more difficult than equity markets, especially for the retail investors.
Tax is going to be a big dagger for most investors to try and do anything. So, unless your goal is close by and you are going to need this money, try and do something. Otherwise, completely avoid trying to actively time the market which most of us will not be able to.
If you try and keep your average maturity as low as possible, you will be able to take advantage of the reinvestment.
So, if you invest in a liquid fund or an ultra-short-term fund which is investing in CP Series for two months or three months, at the end of this duration when rates go up again and when it gets reinvested, your fund will be able to do better.
Mr. Bagla, your email suggest that retail should break the fixed income part of the portfolio and mix many kinds of funds. Can you elaborate on that?
SANDEEP BAGLA: It is difficult to time the market and the volatilities have increased. There have been instances of the central bank, at the instance of any possible disruption to the economy, stepping in and their balance sheets keep going.
So, in that scenario, break your investments into various categories. If you can do that, as per your investment horizon, that would be great. Otherwise, you invest partly into corporate bond funds, partly in banking public sector undertaking debt funds because the quality is typically good.
Have some money in the money market or liquid funds for liquidity management. Probably, take some duration call as well. Although my personal sense at this point of time is that typically 10-year yield in India trades at about 250 basis points, higher than expected inflation, then the fair value should be closer towards 7, 7.5. I would still say that lower your allocation by 10% but put 10% in duration funds, as one never knows when one cannot time the market. Once things go out, they will rebalance the portfolio. So, besides the credit funds, I would suggest that in every market maturity bucket, you split your investment as per your preference.
Kirtan, do you agree? If one of the clients is coming to you and asking you a fresh money to be put to work on the debt side, what would you advise?
KIRTAN SHAH: I don’t want to go to this very basic saying, “keep money at the lower end of the curve”. There are three ways I will look at this situation.
The first way is keeping it simple, like you would do in a fixed deposit. If you really want to deploy this cash for three years, try and find a fund which will have three years of average maturity like you would do in a fixed deposit. If you want to invest for three years, you try and do a three-year fixed deposit.
This will make sure that, in the near term, if there is volatility at the end of the day, you are okay to ride the volatility curve because you are okay to invest. The simplest way to do it is to try and match your investment horizon with the average maturity.
The second is a more asset allocation-based approach, where (you) try and split this fixed income investment into three buckets. First, do liquidity, second, do core, and third, do satellite or tactical.
So, let’s say you have 10% of your money or 15% of your money in liquid funds or ultra-short-term funds. That will largely take care of the liquidity that you need as and when depending on your risk profile, and create the 70% of core market.
So, if you are conservative, try and keep that in short-term debt funds. If you are moderate, you can do banking and PSU corporate bond funds. Let’s say you are aggressive, you can do a combination of medium-term funds plus credit, depending on your risk profile; that’s 70% and the remaining 20% is satellite or more aggressive. Having a small part of your portfolio, which is slightly aggressive than your core and liquid, is okay. And that’s how an asset allocation is typically done.
So, depending on your risk profile you choose what part of your portfolio do you want to keep for this 20%. Let’s say, if I am conservative and I have kept 10% in liquid, 70% in short-term debt fund, the remaining 20% can probably go as a combination of 10% in medium and 10% to credit. This depends again but largely this will diversify the portfolio.
The third is more tactical in nature. For somebody who understands fixed income or believes that the adviser understands and will advise correctly, if you looked at historical data points over the last 20 years, you would see that in every interest rate rising, market barbell as a strategy has really worked out for the investors.
Keep it very simple. You have got Rs 100 to invest, put Rs 50 at the lower end of the curve and put Rs 50 at the higher end of the curve.
This strategy has almost always worked in a rising interest rate environment, but you should only do this with at least a three-years investment horizon in mind or you will get caught on the wrong end.
Mr. Bagla, a fund manager within his or her mandate will be doing things to mitigate the risks as much as possible, but what is it that the fund managers are doing? There is this concept of active fund management. It could be interpreted in various ways. Can you talk a bit about that? Could you also give us some recommendations.
SANDEEP BAGLA: Most fund managers anticipating rapid hikes in interest rates would have reduced their maturity substantially. So, for example, in the short term, if the mandate is to remain between a duration of one to three years, most fund managers would be anywhere closer to 1.5 to 1.75. So, they have reduced it to that extent so the active fund managers can manage things. Then of course, a lot of alphas can be generated.
And if interest rates are on the way down, a lot of double-digit returns can also come from income funds. But, this is not to be ignored. Fund managers have reduced the duration and improved the credit quality of their funds in order to improve the liquidity situation, as well as to reduce the interest component of the funds that they are investing in.
Kirtan, we have seen what an individual investor ideally should do. Now, within these buckets, are there funds that you believe an investor could ideally look at, from a separate house or a different category?
KIRTAN SHAH: An investor should definitely keep in mind to not try and invest in tech funds with lower yield because they are typically the ones who are going to find it extremely difficult if there is a liquidity crunch tomorrow. We have seen this happening multiple times. This is one simple yet extremely important data point which retail investors should keep in mind.
Now, let’s say, if you talk about the longer end of the curve, because I had said you can do a barbell and 50% at the lower end, and 50% at the higher end. At the higher end, you can look at Aditya Birla Sun Life Government Securities Fund. We also spoke about medium-term funds in the tactical asset allocation. You can look at SBI Magnum for medium duration. At the shorter end of the curve, you can look at ICICI short term credit.
For the next two or three years, I am personally very gung-ho about credit. For somebody who understands it and is willing to take a slight risk, credit is a very good opportunity today. HDFC and ICICI credit makes a lot of sense to me.